Lesson 8 of Investment Planning: Derivatives

Question 1

Options

Answer 1

• An option is a derivative security.
• The value of the option depends on (is derived from) the value of another underlying asset.
• The option contract is an agreement between two parties, the seller (or writer) and the buyer.
• All transactions are handled through an option clearing house.
• One option contract controls 100 shares of the underlying security.
  • One option contract with a premium of $2 will cost $200 ($2 × 100).
  • Five option contracts with a premium of $4 will cost $2,000 ($4 × 500).

Question 2

Call Options

Answer 2

A call option is the right to buy a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options).

Question 3

Put Option

Answer 3

A put option is the right to sell a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options).

Question 4

Diagram of call option and put options transaction from both sides:

Answer 4

If the price of the underlying asset falls below the strike price, the put options become “in the money,” meaning they have intrinsic value.
The increase in intrinsic value can surpass the initial premium paid by the investor, resulting in a profit.

Question 5

Exam Tip

Answer 5

If the CFP exam asks which option will provide the maximim gains if the stock appreciates, the right answer is “Buying a Call”

If the CFP Exam asks about maximizing gains if the stock price falls, the right answer is “Buying a Put”

Question 6

The three reasons people invest in options?

Answer 6

1. Hedging
2. Speculation
3. Income

Question 7

An option consists of a Intrinsic Value and a Time Premium

Answer 7

Intrinsic Value:

• Call option = Stock Price - Strike Price
• Put Option = Strike Price - Stock Price
• The intrinsic value cannot be less than 0

Time Value = Premium - Intrinsic Value

What is another name for Stock Price? The Market Value

Question 8

Exam Tip

Answer 8

A Call option is most likely to be tested but make a flashcard and memorize how to calculate intrinsic value of a call and put option. It’s also critical to remember that intrinisc value CANNOT be less than zero.

Question 9

In the Money, At the Money, Out of the Money

Answer 9

Exam Tip: At & Out of the money options have an intrinsic value = 0.

Question 10

Exam Question

Holly purchases a call option on Starbucks. The strike price is $50 and the stock is trading at $53. The call expires in two months and the premium is $5. What is the intrinsic value of her call option?

a) $2
b) $3
c) $4
d) $5

Answer 10

Answer: B

Call option intrinsic value = Stock Price - Strike Price

Intrinsic Value = $53 - $50
Intrinsic Value = $3

The time component = $5 - $3 = $2

Question 11

Exam Question

Holly purchases a put option on Starbucks. The strike price is $50 and the stock is trading at $40. The call expires in two months and the premium is $13. What is the intrinsic value of her put option?

a) $2
b) $3
c) $10
d) $-10

Answer 11

Answer: C

Put option intrinsic value = Strike Price - Stock Price

Intrinsic Value = $50 - $40
Intrinsic Value = $10

The time component = $13 - $10 = $3

Question 12

Calculating a Gain or Loss Using Options

Answer 12

To determine the gain or loss of an option, consider two components:

-The intrinsic value of the option, and
-The premium paid or received.

Question 13

What is the mnemonic you should use to calculate the total gain or loss on an option position?

Answer 13

STOPS

St: Stock gain or loss - if you own the underlying stock.
O: Options gains or loss.
P: Premium paid or received.
S: Shares controlled or owneed.

Question 14

Example of Gain or Loss on an Option Position

Timmy Purchases 5 call options on GAP with a strike price of $20, for a $1 premium. The stock is trading at $18 when Timmy purchases the call option. At expiration, the stock price is trading for $27. What is Timmy’s gain or loss on the transaction?

Answer 14

St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinisc Value = Stock Price - Strike = $27 - $20 = $7.

P: Premiums paid -$1

S: Shares = 500

Gain or loss Equals = ($7 + -$1) x 500
=$3,000 Gain

Question 15

Exam Question

Walter purcahses 2 call options on ABC with a strike price of $50, for a $3 premium. At expiration, the stock is trading for $27. What is Walter’s gain or loss on the transaction?

Answer 15

St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinisc Value = Stock Price - Strike = $27 - $50 = $0 (cannot have a negative value so 0)

P: Premiums Paid -$3

S: Shares = 2

Gain or loss Equals = (-$0 +-$3) x 200
=$600 Loss

Question 16

Exam Question

Harold purchases 3 put options on XYZ with a strike price of $30, for a $1 premium. The stock is trading at $35 when Harold purchases the put option. At expiration, the stock is trading for $27. What is Harold’s gain or loss on the transaction?

a) $600 Gain
b) $600 Loss
c) $300 Gain
d) $300 Loss

Answer 16

Answer: A

St. He doesn’t own the underlying stock, no gain or loss on the stock.

Intrinsic value = Strike - Stock Price = $30 - $27 = $3

Premium paid = <$1>

S: Shares = 300
Gain or Loss Equals: ($3 + <$1>) x 300 = $600 Gain.

Question 17

Exam Question

Tom sells 5 call options on ACME with a strike price of $20, for a $1 premium. The stock is trading at $18 when Tom sells the call options. At expiration, the stock is trading for $27. What is Tom’s gain or loss on the transaction?
a) $3,000 Gain
b) $3,000 Loss
c) $7,000 Gain
d) $7,000 Loss

Answer 17

Answer: B
St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Stock Price - Strike = $27 - $20 = $7 (IMPORTANT NOTE - When SELLING a call, the investor would have to buy the call option to close out the position. You must calculate this as a LOSS of $7 per share because he would have to buy the option back.)

P: Premium Received = $1
S: Shares = 500
Gain or Loss Equals: (-$7+ $1) x 500 = $3,000 Loss.

In this example, the Stock is Above Strike so it won’t be zero. You can exercise it. As the seller you are obligated to buy the higher of the prices.

Question 18

Exam Question

Sherri sells 10 put options on ABC Inc. with a strike price of $50, for a $3 premium. The stock is trading at $52 when Sherri sells the put options. At expiration, the stock is trading for $30.
What is Sherri’s gain or loss on the transaction?

a) $20.000 Gain
b) $20.000 Loss
c) $17,000 Gain
d) $17,000 Loss

Answer 18

Answer: D

St: She doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Strike - Stock Price = $50 - $30 = $20 (IMPORTANT NOTE - When
SELLING a put, the investor would have to buy the put option to close out the position. You must calculate this as a LOSS of $20 per share because she would have to buy the option back)

P: Premium Received = $3

S: Shares = 1,000

Gain or Loss Equals: (<$20> + $3) × 1,000 = $17,000 Loss.

Question 19

Open Trading Strategies

Answer 19

Covered Call
Married Put

Question 20

Covered Call

Answer 20

Involves selling call options on stock that is currently owned by the investor.

This strategy is appropriate for a stock that has been in a trading range, and the investor wants to generate some income but continue to own the stock.

This strategy may also be appropriate if an investor is considering selling a stock, but wants to generate some additional premium dollars and possibly get out of the stock.

Question 21

Married Put

Answer 21

This strategy involves buying a put option on a stock or index that is currently owned by the investor.

This strategy also could be called a “portfolio insurance” if the investor owns a diversified portfolio of common stocks.

Question 22

Exam Tip

Answer 22

When asked a question about “protecting profits” or “locking in gains” the right answer is always buying a put. This is true whether it’s a put on a single stock or an index to protect a diversified portfolio of common stock.

Question 23

Straddles

Answer 23

Long Straddle
Short Saddle

Question 24

Long Straddle

Answer 24

An investor buys a put and a call option on the same stock.

The investor expects volatility, but is unsure as to the direction.

For example: Delta Airlines is announcing that it will be purchasing new jet planes for its fleet, and the competition is between Boeing and McDonnell Douglas. One company’s stock will increase when they win the contract, the other stock is going down when they lose the contract. An investor would purchase a put and call option on both Boeing and McDonnell Douglas.

Question 25

Short Straddle

Answer 25

An investor sells a put and a call option.

The investor does not expect volatility and is hoping to keep the premiums with little to no volatility in the stock price.

Question 26

Collar or Zero-Cost Collar

Answer 26

A strategy when the investor owns the underlying stock, but wants to protect the downside risk without paying the entire cost of the put option.

An investor sells a call option at a strike price that is slightly higher than the current stock price. This creates a premium received.

The investor then buys a put option that is below the current stock price. The premium dollars received by selling the call are used to buy the put options.

Question 27

Option Pricing Models

Answer 27

Black / Scholes
Put / Call Parity
Bionomial Pricing Model

Question 28

Black / Scholes

Answer 28

The Black Scholes Model is used to determine the value of a CALL option.

The Black Scholes Model considers the following variables:
-Current price of the underlying asset.
-Time until expiration.
-The risk-free rate of return.
-Volatility of the underlying asset.

All variables have a direct relationship on the price of the option, except the strike price.

As the strike price increases, the option premium decreases in value.

Question 29

Put / Call Parity

Answer 29

Attemps to value a PUT option based on the value of a corresponding call option.

Question 30

Bionomial Pricing Model

Answer 30

Attempts to value an option based on the assumption that a stock can only move in one of two directions.
- For example, over the short-term you have determined that a security, now worth $10, will be either $12 or $8.

This model can then be extrapolated further into the future based on the value achieved at each interval.

These models are fairly simplistic but are used by many of the major brokerage houses in option valuation.

Question 31

Binominal Pricing Model Below

Answer 31

As you can see above, the value today is $10 and the value at the end of period 1 could be either $12, the price increased, or $8, the price decreased. At the end of period two the price could have continued to increase from $12 to $14 or it could have decreased from $12 back down to $10. If the stock started out down it could have then risen in price from $8 to $10 or continued to fall to $6.

Question 32

Exam Tip

Answer 32

Make a flashcard for all pricing models. The keys are to know:

Black Scholes and the variables it considers.

Put/Call Parity attempts to value a PUT option based upon a call option.

Binomial Pricing Model explains prices based upon the underlying asset price moving
in two directions.

Question 33

Taxability of Options

Answer 33

Call option creates two potential tax consequences:

If the contract lapses (or expires) then the premium paid is a short-term loss and the premium received is a short-term gain.

If the contract is exercised, the premium is added to the stock price to increase the basis in the underlying stock. If the underlying stock is held for more than 12 months, it will be considered a long-term capital gain or loss. If it’s held less than or equal to 12 months, it is considered a short-term gain or loss.

A put option is not likelv to be tested. Just know that if the contract expires without being exercised, the premium paid is a short-term loss and the premium received is a short-term gain.

Question 34

Long Term Equity Anticipation Securities (LEAPS)

Answer 34

Long-Term Equity Anticipation Options that have longer expiration periods than traditional options.

LEAPS have expiration periods that last for two years or more versus traditional options that have expirations up to 9 months.

The premium associated with LEAPS is higher because of the extended time period.

Question 35

Warrants

Answer 35

Warrants are essentially long-term call options issued by the **corporations. **
-Call options written by investors.

The expiration period is much longer than options, usually 5-10 years.
-Call options have expiration periods of 9 months or less.

Warrant terms are NOT standardized.
-Call option contracts are standardized in terms of expiration month and number of shares collected.

Question 36

Exam Question

A call option with a strike price of $110 is selling for $3.50 when the market price of the underlying stock is $108.

The intrinsic value of the call is:

a) $0
b) $1.50.
c) $2.
d) $3.50.
e) $-2.

Answer 36

Answer: A
Call = Stock Price - Strike Price

Call = $108 - $110

Call is out of the money, therefore, zero intrinsic value. Remember, intrinsic value cannot be less than zero. The $3.50 premium represents the time premium only.

Question 37

Exam Question

A client purchased 100 shares of Yahoo at $30. Yahoo is now trading at $42. The client buys a put option with a strike price of $40 for $1. How much would the client make (in total) if the stock was trading at $35 on the expiration date?

a) $500
b) $600
c) $700
d) $800
e) $900

Answer 37

Answer: E

St: $35 - $30 = $5 per share
O: Strike - Stock = $40 - $35 = 55
P: $-1 premium paid
S: 100
Gain or Loss: ($5 + $5 + <$1>) × 100 = $900

Question 38

Exam Question (Part 1 of 3)

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

Question 1) What is the client’s gain or loss (per share) if the stock closes at $45 on expiration?
a) $2 Loss Per Share.
b) $2 Gain Per Share.
c) $6 Gain Per Share.
d) $14 Loss Per Share.

Answer 38

Answer: D

Call Option:
St $0 (doesn’t own the underlying stock)
O: (Stock Price - Strike Price) = $45 - $50 = $0 (cannot have a negative intrinsic value).
P: -$6 premium paid
S: N/A - Question asks about per share gain or loss
Call Gain or Loss = $0+ $0 + <$6> = -$6

Put Option:
St. $0 (doesn’t own the underlying stock)
O: (Strike Price - Stock Price) = $40 - $45 = $0 (cannot have negative intrinsic value)
P. -$8 premium paid
S: N/A - Question asks about per share gain or loss
Put Gain or Loss = $0 + $0 + -$8 = -$8

Total Gain or Loss - Call Loss of $6 + Put Loss of $8 =$14 Loss per share

Question 39

Exam Question (Part 2 of 3)

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

Question 2) What is the client’s gain or loss (per share) if the stock closes at $60 per share on expiration?
a) $2 Loss Per Share.
b) $4 Loss Per Share.
c) $8 Gain Per Share.
d) $14 Gain Per Share.

Answer 39

Answer: B

Call Option:
St: $0 (doesn’t own the underlying stock)
O: (Stock Price - Strike Price) = $60 - $50 = $10
P: -$6 premium paid
S: N/A - Question asks about per share gain or loss
Call Gain or Loss = $0 + $10 + -$6 = $4

Put Option:
St. $0 (doesn’t own the underlying stock)
O: (Strike Price - Stock Price) = $40 - $60 = $0 (cannot have negative intrinsic value)
P. -$8 premium paid
S: N/A - Question asks about per share gain or loss
Put Gain or Loss = $0 + $0 + -$8 = -$8

Total Gain or Loss - Call Gain of $6 + Put Loss of $8 =$4 Loss per share

Question 40

Exam Question (Part 3 of 3)

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

Question 2) What is the client’s gain or loss (per share) if the stock closes at $30 per share on expiration?
a) $2 Loss Per Share.
b) $4 Loss Per Share.
c) $8 Gain Per Share.
d) $14 Gain Per Share.

Answer 40

Answer: B

Call Option:
St: $0 (doesn’t own the underlying stock)
O: (Stock Price - Strike Price) = $30 - $50 = $0 (cannot have a negative sign)
P: -$6 premium paid
S: N/A - Question asks about per share gain or loss
Call Gain or Loss = $0 + $0 + -$6 = -$6

Put Option:
St. $0 (doesn’t own the underlying stock)
O: (Strike Price - Stock Price) = $40 - $30 = $10 (cannot have negative intrinsic value)
P. -$8 premium paid
S: N/A - Question asks about per share gain or loss
Put Gain or Loss = $0 + $10 + -$8 = $2

Total Gain or Loss - Call Loss of -$6+ Put Gain of $2 =$4 Loss per share

Question 41

Exam Question

Theresa sells a call option for a premium of $5. The call has an exercise price of $50. Which of the following statements is true?
a) Theresa’s maximum gain potential is $50.
b) Theresa’s maximum loss potential is $45.
c) Theresa’s maximum gain potential is unlimited.
d) Theresa’s maximum loss potential is unlimited.

Answer 41

Answer: D

By selling a call option, Theresa has given the buyer the right to buy a stock from her for $50 per share. Theoretically, the stock could go to infinity; therefore, Theresa would have to buy the stock at that price and then sell it to the option buyer at $50 per share. Therefore, Theresa’s loss potential is unlimited.

Question 42

Exam Question

With the same dollar investment, which of the following strategies can cause the investor to experience the greatest loss? (CFP Certification Examination, released 3/95)
a) Selling a naked put option.
b) Selling a naked call option.
c) Writing a covered call.
d) Buying a call option.
e) Buying the underlying security.

Answer 42

Answer: B

Selling a naked call has the greatest loss potential. When selling a naked put, the most an investor could lose is the strike price because the stock could fall to zero and the investor would be forced to buy the stock at the strike price. Writing a covered call is relatively conservative because the option seller owns the underlying asset. Anytime an investor buys an option, the maximum loss is limited to the premium paid. When buying the underlying security, the maximum loss is the stock price paid.

Selling a Naked Call Option:
When an investor sells a naked call option, they have an obligation to sell the underlying security at the specified strike price if the option is exercised.
The potential loss is theoretically unlimited, as there is no cap on how much the price of the underlying security can rise.
This strategy exposes the investor to significant risk if the market price of the underlying security increases substantially.

Other Strategies:
Buying a call option (d) and buying the underlying security (e) both have a limited loss potential. The investor can lose the entire premium paid for the call option, but their loss is capped.
Writing a covered call (c) has limited loss potential as well. The investor owns the underlying security, and while they may miss out on potential gains if the stock price rises significantly, their loss is limited to the stock’s decline.

Question 43

Future Contracts

Answer 43

Two types of future contracts:
1. Commodity Future Contracts
2. Financial Futures Contracts

Two primary players in the futures markets are hedgers and speculators.

Future contracts are “marked to market”
-The gain or loss (in cash) is credited / debited to your account on a daily basis.

Question 44

Commodity Future Contract

Answer 44

Where the underlying asset is:

Copper, wheat, pork bellies, oil.

Question 45

Financial Future Contracts

Answer 45

Where the underlying asset is:

Currency, interest rate, and stock indices.

Question 46

Important Differences between Futures and Option Contract

Answer 46

Option contracts give the holder the right to do something.

Future contracts obligate the holder to make or take delivery of the underlying asset.

Future contracts do not state the per unit price of the underlying asset, which is determined by supply and demand.

Question 47

Process of Hedging a Position

Answer 47

The examples below show how future contracts can be used to hedge a position. Hedging is one of the possible testing question refarding futures on the CFP exam.

Question 48

How Futures Can Hedge a Position Position 1

Answer 48

Position 1 - Long the commodity, Short the contract

An orange grove owner has production costs and knows the price he must receive per bushel to make a profit, given these costs. The future orange price is unknown, but the current price for a contract for future delivery is known. The owner sells a contract for future delivery as a hedge position. He is long the commodity (the oranges in the trees), and short the futures contract to lock in his sale price,

Explanation: Basically what this means is the owner is agreeing to SHORT the oranges in a future contract. He is agreeing to sell the oranges for a predetermined price in the future in case the oranges lose value to protect himself in case of price declines in the orange market. This is protecting him from risk.

The owner is LONG in the market which means he will own them in the future. He already has ownership in the future, so when they marvest he wants to make sure he can sell them.

Question 49

How Futures Can Hedge a Position Position 2

Answer 49

Position 2 - Short the commodity, Long the contract

A manufacturer of orange juice (user of oranges) hedges in the opposite direction. The juice maker buys a futures contract and has a long position in the contract and a short position in the manufacturing costs of juice in the future.

Short the commodity: The entity takes a short position on the physical commodity itself. In this case, the orange juice manufacturer is effectively selling oranges short. This means they are selling oranges they do not currently own, with the expectation that they can buy them back at a lower price in the future.

Long the contract: The entity takes a long position on a futures contract for the commodity. By buying a futures contract, the orange juice manufacturer secures the right to purchase oranges at a specified price in the future. This protects them from potential price increases in the orange market, as they can buy oranges at the predetermined price even if the market price rises.

Question 50

Exam Question

A money fund manager in the United Kingdom, is concerned about a decrease in the British Pound. What should the fund manager do?
a) Purchase a futures contract on the British Pound.
b) Buy a futures contract on the US Dollar.
c) Sell a futures contract on the US Dollar.
d) Sell a futures contract on the British Pound.

Answer 50

Same as position 1.

Answer: D

In the currency example, the money fund manager is not technically “long” the British Pound, but they already hold British Pounds.

In the currency example, the money fund manager sells a futures contract on the British Pound, taking a short position on the currency. He is locking in a selling price for the currency just like with the “oranges.”

The fund manager is inherently long on the British Pound. To hedge the fund managers risk, the manager should enter into an opposite position. The opposite position would be to short the British Pound. This is accomplished by selling a futures contract

Question 51

What best describes a long hedge position?

Answer 51

A long position in a futures contract is when the investor buys a future contract
- A long hedge means that the investor owns buys the futures to insure a certain price of a commdiuty that he or she does not yet own.

A short position in a futures contracts is when the investor sells a futures contracts.\