Options Basics

Question 1

If an equity call holder exercises a contract, the holder must deliver:

A. cash in 1 business day
B. stock in 1 business day
C. cash in 2 business days
D. stock in 2 business days

Answer 1

The best answer is C.

If the holder of an equity call exercises, he is buying the stock at the strike price. Settlement is 2 business days after exercise date - this is a regular way stock trade.

Question 2

A customer would sell call contracts because the customer:

A. is bullish on the underlying security
B. is bearish on the underlying security
C. wishes to generate earned income
D. wishes to defer taxation of gains on the underlying stock

Answer 2

The best answer is B.

Call contracts are sold when a customer is bearish on the market. If the market falls, the calls expire “out the money” and the writer retains the premiums earned. This is the maximum potential gain for the writer of a call. When the calls expire, the premium received is treated as a short term capital gain for income tax purposes. It is not earned income (which is income from one’s occupation) - rather it is “portfolio income,” making Choice C incorrect.

Question 3

An investor writes 1 ABC Jan 45 Call @ $3. The contract subsequently is exercised. The writer is obligated to:

A. buy stock at $45 per share
B. buy stock at $48 per share
C. sell stock at $45 per share
D. sell stock at $48 per share

Answer 3

The best answer is C.

The writer of a call is obligated to sell stock at the strike price of $45 per share specified in the contract, if exercised. For selling the contract, the writer initially receives a premium of $3 per share.

Question 4

The holder of a put on a listed stock exercises. The holder must:

A. deliver cash
B. deliver stock
C. take delivery of stock
D. take delivery of the premium

Answer 4

The best answer is B.

If the holder of a put option on a listed stock exercises, he or she must deliver 100 shares of stock, for which the holder will receive the strike price in cash.The premium is received at the time of the initial trade, not upon exercise.

Question 5

A customer would buy put contracts because the customer:

A. is bullish on the underlying security
B. is bearish on the underlying security
C. is neutral on the underlying security
D. wishes to generate ordinary income

Answer 5

The best answer is B.

Put contracts are purchased when a customer is bearish on the market. If the market falls, the puts go “in the money” and the holder would exercise, selling the stock for the strike price that is higher than the current market price. The maximum potential gain for the holder of a put will occur if the price falls to “0.” Because the holder of a put pays a premium and does not earn this premium, this is not an income strategy, making Choice D incorrect.

Question 6

If the writer of an equity put contract is exercised, the writer must deliver:

A. cash in 1 business day
B. stock in 1 business day
C. cash in 2 business days
D. stock in 2 business days

Answer 6

The best answer is C.

If the writer of an equity put contract is exercised, he is obligated to buy the stock at the strike price (paying cash) from the holder of the put. Settlement is 2 business days after exercise date - this is a regular way stock trade.

Question 7

The writer of a put on a listed stock is exercised. Upon assignment, the writer must:

A. pay the premium
B. deliver cash
C. buy stock
D. sell stock

Answer 7

The best answer is C.

If the writer of a put option on listed stocks is exercised, he or she must buy 100 shares of stock, for which the writer will pay the strike price in cash.

Question 8

A customer would sell put contracts because the customer:

A. is bullish on the underlying security
B. is bearish on the underlying security
C. wishes to generate ordinary income
D. wishes to defer taxation of gains on the underlying stock

Answer 8

The best answer is A.

Put contracts are sold when a customer is bullish on the market. If the market rises, the puts expire “out the money” and the writer retains the premiums earned. This is the maximum potential gain for the writer of a put. When the puts expire, the premium received is treated as a short term capital gain for income tax purposes. It is not ordinary income - rather it is “portfolio income,” making Choice C incorrect.

Question 9

If an equity put writer is exercised, the writer has the obligation to:

A. deliver cash in 1 business day
B. buy stock in 1 business day at the market price
C. buy stock in 2 business days at the market price
D. buy stock in 2 business days at the strike price

Answer 9

The best answer is D.

Equity put writers have the obligation to buy the stock during the lifetime of the option at the strike price (NOT the market price, as the market will be lower than the strike if the contract is exercised). If exercised, the writer must pay the strike price for the stock position 2 business days after trade date.

Question 10

An investor writes 1 ABC Jan 45 Put @ $3. The contract subsequently is exercised. The writer is obligated to:

A. buy stock at $42 per share
B. buy stock at $45 per share
C. sell stock at $42 per share
D. sell stock at $45 per share

Answer 10

The best answer is B.

The writer of a put is obligated to buy stock at the strike price of $45 per share specified in the contract, if exercised. For selling the contract, the writer initially receives a premium of $3 per share.

Question 11

The option premium is:

A. the price of the contract
B. the strike price of the contract
C. recalculated at the end of each trading day
D. determined by the Options Clearing Corporation

Answer 11

The best answer is A.

The option premium is the price of the contract. The price is determined on the floor of the options exchange, based upon market conditions for that contract.The premium fluctuates throughout the day as would the price of the underlying stock

Question 12

The premium on a call or put option is the:

A. exercise price of the contract
B. cost of the contract
C. market price of the underlying instrument
D. cost of the underlying instrument

Answer 12

The best answer is B.

The premium on an option contract is the market price of the contract.

Question 13

The “cost” of an option contract is the:

A. premium
B. exercise price
C. market price of the underlying security
D. intrinsic value

Answer 13

The best answer is A.

The cost of an option contract is the premium, paid from option buyer to option seller. The exercise price is the price of a trade in the underlying security, if the contract is exercised. Intrinsic value is the profit to the holder that would result from an exercise (ignoring premiums paid).

Question 14

ABC Jan 50 call contracts are trading in the market at .65. What is the dollar price that a customer would pay for 2 contracts at this price?

A. $65.00
B. $130.00
C. $130.50
D. $260.00

Answer 14

The best answer is B.

A premium of .65 is $.65 per share. Equity contracts cover 100 shares, so the total premium is $.65 x 100 = $65.00 per contract. Since there are two contracts, the total premium would be $130.

Question 15

A profit to the holder resulting from exercise of an option contract is the:

A. premium
B. time value
C. “out the money” amount
D. “in the money” amount

Answer 15

The best answer is D.

Intrinsic value is the profit to the holder that would result from an exercise (ignoring premiums paid). Intrinsic value is the same thing as the “in the money” amount Time value is any premium amount paid that is above the “in the money” amount. The cost of an option contract is the premium, paid from option buyer to option seller. The components of the premium are the “in the money” amount; and the time premium.

Question 16

What is the “intrinsic value” of the following contract?

1 ABC Jan 55 Put @ $9
ABC Market Price = $49

A. $2
B. $4
C. $6
D. $8

Answer 16

The best answer is C.

Intrinsic value is the amount by which an option contract is “in the money” - it has nothing to do with the premium. It is the difference between the strike price and market price, if exercise is profitable to the holder. In this case, the holder of the put can sell the stock at the strike price of $55 when the market price is $49, for a $6 profit to the holder. This is the “intrinsic value” of the contract.

Question 17

An option contract is “out the money” if:

A. exercise is unprofitable to the holder, ignoring the premium paid
B. exercise is unprofitable to the writer, ignoring the premium received
C. exercise is unprofitable to the holder, including the premium paid
D. exercise is unprofitable to the writer, including the premium received

Answer 17

The best answer is A.

The “out the money” amount is the loss to the holder that would result from an exercise (ignoring premiums paid). This occurs if the market price falls below the strike price on a call contract; and when the market price rises above the strike price on a put contract. An “out the money” contract is one that the holder would let expire worthless. Please note that if an “out the money” contract still has time to expiration, it could also be traded in the market.

Question 18

A client buys an ABC Jul 50 Call @$2 when the stock is trading at $55. The contract:

A. is out of the money
B. has 2 points of intrinsic value
C. has 3 points of intrinsic value
D. has 5 points of intrinsic value

Answer 18

The best answer is D.

In the money and out the money amounts for options contracts disregard the premium amount. The holder of this call has the right to buy ABC stock at $50 per share when the market price of ABC is at $55, so the contract is 5 points “in the money” – meaning there is a 5 point profit at this moment to the holder, disregarding the premium paid. If the question asked “What is the profit or loss?” then the answer would be a 3 point profit because 2 points were paid in premiums.

Question 19

What is the “out the money” amount for the following contract?

1 ABC Jan 45 Call @ $4
ABC Market Price = $44

A. 0
B. 1
C. 3
D. 4

Answer 19

The best answer is B.

An option contract is “out the money” if exercise would be unprofitable to the holder, ignoring any premiums paid. Such a contract would be allowed to expire unexercised. In this case, the holder of the call can buy the stock at the strike price of $45 when the market price is $44, for a $1 loss to the holder. This contract is “out the money” by $1 and would be left to expire unexercised.

Question 20

What is the “out the money” amount of the following contract?

1 ABC Jan 55 Put @ $2
ABC Market Price = $61

A. $2
B. $4
C. $6
D. $8

Answer 20

The best answer is C.

The “out the money” amount is the loss that would be experienced upon exercise of an option contract. It is the difference between the strike price and market price, if exercise is unprofitable to the holder. Such a contract would be left to expire unexercised. In this case, the holder of the put can sell the stock at the strike price of $55 when the market price is $61, for a $6 loss to the holder. This contract is “out the money” by $6 and would expire unexercised.

Question 21

Which statement is TRUE about option contracts?

A. “In the money” means a contract has intrinsic value
B. “In the money” means an options trade is profitable for a contract holder
C. “In the money” means an options trade is profitable for either a contract holder or writer
D. If a contract is “in the money” for a buyer, by definition it means the same contract is “out of the money” for a writer

Answer 21

The best answer is A.

Puts go “in the money” when the market price falls below the strike price and calls go “in the money” when the stock rises above the strike price - it makes no difference if the contract is “long” or “short.”

Being “in the money” simply means the contract has intrinsic value - and that if the contract were at expiration, the holder would either trade it out at its intrinsic value (there is no time value because the contract is at expiration) or would exercise the contract.

Note, however that just because a contract has “intrinsic value” does not mean that it is profitable. For example, if a call buyer paid a premium of 9 for a contract that has intrinsic value of 3 (3 points “in the money), the position is still unprofitable (by 6 points), even though the contract is “in the money.”

Question 22

Which statement is TRUE about option contracts?

A. Long calls go “out the money” when the market price rises above the strike price
B. Long puts go “out the money” when the market price falls below the strike price
C. Short calls go “out the money” when the market price rises above the strike price
D. Short calls go “out the money” when the market price falls below the strike price

Answer 22

The best answer is D.

An “out the money” contract is one, that if exercised, would result in an unprofitable stock trade to the holder. These contracts are left to expire unexercised.

Calls go “out the money” when the market price falls below the strike price and “in the money” when the market price rises above the strike price - it makes no difference if the contract is “long” or “short.” Being “out the money” is bad for the contract holder and good for the contract writer. The call holder would not exercise and buy the stock at a strike price that is higher than the current market.

Note, in contrast, that puts go “out the money” when the market price rises above the strike price. The put holder will not exercise and sell stock at the strike price that is lower than the current market price.

Question 23

Which statement is TRUE about option contracts?

A. Calls go “out the money” when the market price rises above the strike price
B. Calls go “out the money” as the option nears expiration
C. Puts go “out the money” when the market price rises above the strike price
D. Puts go “out the money” as the option nears expiration

Answer 23

The best answer is C.

An “out the money” contract is one, that if exercised, would result in an unprofitable stock trade to the holder. These contracts are left to expire unexercised.

Calls go “out the money” when the market price falls below the strike price. The call holder would not exercise and buy the stock at a strike price that is higher than the current market.

Puts go “out the money” when the market price rises above the strike price. The put holder will not exercise and sell stock at the strike price that is lower than the current market price.

When a contract is at expiration, there is no more time value left in the premium. This has nothing to do with intrinsic value.

Question 24

All of the following are advantages of buying a put as compared to selling short stock EXCEPT:

A. lower capital requirement
B. no requirement to borrow shares
C. no requirement to pay interest on a stock loan
D. no loss of time premium as the position is held

Answer 24

The best answer is D.

The advantages of buying a put over selling that security short are a lower capital requirement (paying 100% of the premium is lower than putting up 50% initial margin on the full value of the stock position); no requirement to make up dividend payments on borrowed shares; and no requirement to pay interest on a stock loan of borrowed shares. A disadvantage of holding an option is that every day its time value decreases, to zero at expiration. This does not occur with stock positions, since there is no finite life on the position.

Question 25

The purchase of a call has what advantage over buying the underlying security?

A. Lower capital requirement
B. The call holder receives the same dividend as does the holder of the underlying stock
C. The call holder does not lose time value as the position is held
D. The call holder has a larger gain potential in a rising market

Answer 25

The best answer is A.

The advantage of buying a call over buying the underlying security is a lower capital requirement (paying 100% of the premium is lower than paying for the full value of the stock position).

Call holders do not receive dividends as do stockholders, so this is a disadvantage. Another disadvantage of holding an option is that every day its time value decreases, to zero at expiration. This does not occur with stock positions, since there is no fixed life on the position.

Finally, both long calls and long stock positions give ever-increasing gain in a rising market, so they have similar upside gain potential.

Question 26

The main advantage of buying a call option as opposed to buying the underlying stock is:

A. lower capital requirement
B. both receive dividends from the issuer
C. both have pre-emptive rights
D. greater liquidity

Answer 26

The best answer is A.

The main advantage of buying a call option as opposed to buying the shares of that issuer is that the premium paid is much lower than the cost of buying the stock. However, call holders do not receive dividends, nor do they have any shareholder rights.

Calls lose time premium as they get closer and closer to expiration, whereas stockholders do not experience such a loss.

There is ready liquidity in both the options markets and the stock markets, so there is no meaningful advantage of one as compared to the other in this respect.

Question 27

A customer is short an ABC Jan 60 Call. The position has a profit that the customer wishes to capture. The proper order to enter is a(n):

A. opening purchase
B. closing purchase
C. opening sale
D. closing sale

Answer 27

The best answer is B.

All options orders must be marked either “opening” or “closing.” The OCC maintains the record of all listed options contracts. Opening positions are recorded on the books of the OCC; while orders to close positions remove them from the books of the OCC.

Note that a customer can open by selling an option contract and will close by purchasing that option contract; or the customer can open by purchasing an option contract and will close by selling that option contract.

Question 28

A customer is long an ABC Jan 60 Put. The position has a profit that the customer wishes to capture. The proper order to enter is a(n):

A. opening purchase
B. closing purchase
C. opening sale
D. closing sale

Answer 28

The best answer is D.

All options orders must be marked either “opening” or “closing.” The OCC maintains the record of all listed options contracts. Opening positions are recorded on the books of the OCC; while orders to close positions remove them from the books of the OCC.

Note that a customer can open by selling an option contract and will close buy purchasing that option contract; or the customer can open by purchasing an option contract and will close by selling that option contract.

Question 29

A customer is long an ABC Jan 60 Call. The position has a profit that the customer wishes to capture. The proper order to enter is a(n):

A. opening purchase
B. closing purchase
C. opening sale
D. closing sale

Answer 29

The best answer is D.

All options orders must be marked either “opening” or “closing.” The OCC maintains the record of all listed options contracts. Opening positions are recorded on the books of the OCC; while orders to close positions remove them from the books of the OCC.

Note that a customer can open by selling an option contract and will close buy purchasing that option contract; or the customer can open by purchasing an option contract and will close by selling that option contract.

Question 30

A customer is short an ABC Jan 60 Put. The position has a profit that the customer wishes to capture. The proper order to enter is a(n):

A. opening purchase
B. closing purchase
C. opening sale
D. closing sale

Answer 30

The best answer is B.

All options orders must be marked either “opening” or “closing.” The OCC maintains the record of all listed options contracts. Opening positions are recorded on the books of the OCC; while orders to close positions remove them from the books of the OCC.

Note that a customer can open by selling an option contract and will close buy purchasing that option contract; or the customer can open by purchasing an option contract and will close by selling that option contract.