Series 7 STC Options (Ch. 12) Flashcards
A customer owns an ABC Corporation May 60 call option. If ABC Corporation executes a 5-for-4 split, what will the customer own after the split?
Two calls for 100 shares at a $30 strike price
One call for 125 shares at a $60 strike price
One call for 125 shares at a $48 strike price
One call for 100 shares at a $60 strike price
One call for 125 shares at a $48 strike price
After the execution of the company’s 5-for-4 odd split, the customer will own one call contract representing 125 shares with a $48 strike price. With an odd split, it’s important to note that the number of contracts remains the same. However, the new number of shares per contract can be found by multiplying the original 100 shares by the split ratio (100 shares x 5/4 = 125 shares). The new strike price can be found by multiplying the original strike price by the inverse of the split ratio ($60 strike x 4/5 = $48 new strike).
All of the following statements are TRUE of covered call option writing, EXCEPT:
The writer can increase the overall yield on his portfolio.
It’s considered a conservative option strategy.
The premium received guarantees that the writer cannot have a loss on the underlying security.
The writer will have a short-term capital gain if the option expires unexercised.
The premium received guarantees that the writer cannot have a loss on the underlying security.
The premium received on a covered call is typically not enough protect the potential loss on the stock’s value falling to zero. As a result, the premium received doesn’t guarantee that the writer cannot have a loss on the underlying security. The premium received from a covered call position does increase an investor’s yield and the strategy itself is a conservative one. For tax purposes, if an option expires worthless, the premium received by the seller is taxed as a short-term capital gain.
An investor creates a spread position by purchasing an RST July 50 put at 6 and writing an RST July 70 put at 13. The client will profit if:
The spread narrows
The spread widens
Both options are exercised
The underlying stock price falls
The spread narrows
The client has created a vertical spread. Since the short position is more expensive than the long position, the dominant leg is the short July 70 put option and this is a credit spread (i.e., net seller). Credit spreads will profit if the spread between the premiums narrows. In addition, the dominant leg is a short put and is bullish; therefore, the entire spread is bullish (i.e., profitable if stock price rises). Sellers of options, including spreads, will profit if their option(s) expires. Buyers will typically profit if their options are exercised.
A customer has unlimited risk if he’s:
Long 1 ABC Jan 50 put
Short 1 ABC Jan 50 put
Short 1 ABC Jan 50 put and short 100 shares of ABC stock
Short 1 ABC Jan 50 put and long 100 shares of ABC stock
Short 1 ABC Jan 50 put and short 100 shares of ABC stock
Writing a covered put (short stock + short put) has an unlimited potential loss. Covered puts have unlimited risk because a short stock position will lose as the stock’s price rises and, because there’s theoretically no limit as to how high the price may rise, the potential loss is unlimited. The income generated by selling a put will not be enough to cover or limit the short stock’s losses. The loss on a long put is limited to the premium. The maximum loss on a short put is the strike price minus the premium (i.e., breakeven price) multiplied by the contract size (Short Put Max. Loss = (Strike - Premium) x Contract Size).
The fund manager overseeing a portfolio of oil and gas stocks will MOST likely hedge against a downward movement by purchasing:
Narrow-based index puts
Narrow-based index calls
Broad-based index puts
Broad-based index calls
Narrow-based index puts
Put options are commonly used to protect (i.e., hedge) a long stock position against a decrease in the stock’s price. As prices decline, the value of puts rises which will offset the decrease in the stock position. For a portfolio that consists of companies from one industry, narrow-based index options are the best hedge since their performance will closely follow that industry.
A company in France will be importing California wines. Since the company will be paying in U.S. dollars, it’s concerned that the U.S. dollar will appreciate in value. To provide protection in the event that the U.S. dollar does appreciate, the company could buy:
U.S. dollar calls
U.S. dollar puts
Euro calls
Euro puts
Euro Puts
Due to the inverse relationship between the U.S. dollar and foreign currencies, if the U.S. dollar appreciates, the value of the euro will decline and the French importer will be required to pay additional euros for the wine that it’s buying. Therefore, the company should buy puts on the euro. The company cannot buy U.S. dollar calls since there are no options on the U.S. dollar that trade on an options exchange in the United States. Conversely, if a European exporter is worried that the U.S. dollar will decline, it could buy euro calls.
If a broker-dealer is assigned an option exercise notice on Monday, May 2, on what day will the stock transaction settle?
Tuesday, May 3
Wednesday, May 4
Monday, May 2
Thursday, May 5
Tuesday, May 3
The exercise of an option contract results in stock being either purchased or sold. The settlement of a stock transaction is one business day after the trade date (i.e., T + 1). In this question, the next business day after Monday, May 2, is Tuesday, May 3.
An investor who wants to hedge a portfolio of long-term bonds should buy:
Yield-based call options
Yield-based put options
VIX call options
VIX put options
Yield-based call options
The prices of bonds are inversely related to the movement of interest rates. If the investor is concerned about falling prices for the bonds in her portfolio, she’s also concerned about rising interest rates. The best hedge is to buy yield-based call options. Yield-based calls will increase in value when interest rates rise and bond prices fall. The VIX (the CBOE Volatility Index) tends to move inversely with the S&P 500 Index. The VIX will typically rise when the S&P 500 Index falls, and fall when the S&P 500 Index rises. An investor will buy VIX call options when she expects the market to decline and volatility to increase. Many investors will buy VIX call options as a hedge against a possible decline in the stock market. VIX options can be used by investors who expect either an increase or a decrease in volatility; however, these options are not used to hedge bond portfolios.
An investor writes an uncovered RST May 25 put for a premium of 4. What’s the investor’s maximum loss?
$2,100
$2,500
$2,900
$3,500
$2,100
Writing (i.e., selling) a put is a bullish position which means that the investor will lose if the price of RST’s stock falls. If RST declines to zero and the put buyer exercises the contract, the writer will be obligated to buy 100 shares of RST at the put’s strike price of $25 per share, or $2,500 in total. If the stock is worthless, the writer of the put will immediately lose the $2,500 investment, but will keep the $400 premium received for selling the put ($4 premium x 100 shares). Therefore, the investor’s maximum loss is $2,100 ($2,500 loss on stock- $400 premium received).
An investor who sells an index straddle or combination is anticipating that the market will be:
Bullish
Bearish
Neutral
Volatile
Neutral
A short straddle is an option position that’s created by selling a call and a put on the same underlying stock, with the same expiration date, and the same strike price. A short combination is similar; however, the call and put will have different strikes and/or different expirations. An investor who sells a straddle or a combination is hoping that the options will expire so she can keep the premiums received. This type of investor is neither bullish nor bearish, but is anticipating that the price of the underlying security (or index) will remain relatively stable or neutral.
An investor buys 300 shares of RSW at 15. She then writes three RSW July 20 calls at 1 and writes three 3 RSW July 10 puts at 0.50. The investor’s maximum potential loss is:
Unlimited
$4,050
$4,950
$7,050
$7,050
The investor has written three covered calls and three uncovered puts. In both cases, the maximum loss occurs if the underlying stock (RSW) price falls to zero. If the market price of RSW is zero, the three covered calls would result in a loss of $4,200 (300 shares x $15 purchase price - $300 premium received). At zero, the three uncovered puts are exercised for a net loss of $2,850 (3 contracts x $10 strike price - the premium received of $150). Therefore, the total loss is $7,050 ($4,200 loss on stock and covered calls + $2,850 loss on uncovered puts).
For foreign currencies, closing spot prices are disseminated daily by the:
NYSE
IMM
FRB
FINRA
FRB
The Federal Reserve Board (FRB) disseminates closing spot prices of foreign currencies on a daily basis.
Which of the following could execute a closing sale?
The writer of an option
The owner of an option
The owner of common stock
The seller of common stock
The owner of an option
For the owner of a listed option to offset (i.e., liquidate, sell, or exit) the existing option position, he will execute a closing sale. Whether an option transaction is opening or closing a position, it’s required to be included on the investor’s option order ticket.
An investor purchases a Canadian dollar September 80 call and writes a Canadian dollar September 82 call. This position is a:
Bullish spread
Bearish spread
Long straddle
Credit combination
Bullish Spread
A spread is created by buying and selling options of the same class (i.e., calls or puts), on the same underlying security, but with different strike prices and/or expiration months. If premiums are not provided, the dominant leg is determined by whether it’s a call or put spread. For a call spread, the leg with the lower strike price will be the dominant leg; however, for a put spread, the leg with the higher strike price will be the dominant leg. A debit spread is created when the premium on the long option is greater than the premium on the short option. In the question, the September 80 call (the lower strike price) will have a higher premium than the 82 call; therefore, the investor created a debit spread. Since the September 80 call will have the higher premium, it’s considered the dominant leg and determines the investor’s strategy. Buying calls is bullish and all debit call spreads are a bullish strategy. Credit call spreads (i.e., dominant leg is the short call) are bearish positions because selling calls is a bearish strategy.
An investor notices that the contract size for a listed equity option is 10 shares, while the option’s strike price is 50. What’s the MOST likely explanation?
The underlying stock has paid a cash dividend.
The underlying stock has undergone a reverse stock split.
The underlying corporation recently distributed a stock dividend.
A mistake was made since listed equity options cannot have a contract size of less than 100 shares.
The underlying stock has undergone a reverse stock split.
When a corporation executes a forward or reverse stock split, all of its associated options contracts are adjusted. For a reverse split, the number of shares outstanding is reduced and the stock’s market price increases. As is true for the underlying stock, the execution of the split will reduce the number of shares associated with each option contract and the strike price will be increased. An important note is that the option’s aggregate contract value (strike price x number of shares) will be the same before and after the adjustment. For this question, since the number of shares in the option is only 10, the company most likely performed a 1-for-10 reverse split. The option originally had 100 shares, but has only 10 shares after a 1:10 split (100 shares x 1/10 split ratio). The option’s original strike price must have been $5, but after the 1:10 split, it became $50 ($5 x 10/1). Forward splits and stock dividends both increase the number of shares, rather than reduce them. Options are not adjusted for stock dividends.
A customer sells short 100 shares of XYZ at $40 and sells one XYZ October 40 put at 5. When the market value of XYZ stock is at $35, if the put is exercised and the stock received from the exercise of the put is used to cover the short stock position, what’s the customer’s profit or loss per share?
A $10 profit
A $5 profit
A $5 loss
No gain or loss
A $5 profit
Selling a stock short and then writing a put is referred to as a covered put option. Although it’s referred to as a “covered” position, it’s important to recognize that the investor who creates the position is exposed to unlimited upside risk on the short stock position. As with any short stock position, the investor will generally make money if the underlying stock declines in value (i.e., the investor is bearish). If the stock declines and the put is exercised, the customer is obligated to buy shares at the put’s strike price of $40. Since the stock was originally sold short at $40, there’s no profit or loss when the short position is covered and closed ($40 short sale proceeds- $40 purchase from exercise of put). However, the sale of the put generated premium income of $5, which is the investor’s profit.
When reviewing newspaper listings for foreign currency options, the spot prices for the underlying foreign currencies are quoted in:
European terms
U.S. terms
1/32 of a point
1/8 of a point
U.S. terms
For foreign currency options, spot prices are quoted in U.S. terms. This means that the quote represents what it costs in U.S. dollars to purchase one unit of the foreign currency. With the exception of the Japanese yen, all of the foreign currency spot prices are quoted in cents per unit.
An investor buys 1 ABC May 70 call for a premium of 4. What’s the investor’s maximum loss?
$400
$6,600
$7,400
Unlimited
$400
The maximum loss for an investor who buys a call option is the premium paid. For this question, the investor’s maximum loss is $400 (premium of 4 x 100 shares). Remember, buyers of options cannot lose more than the premium paid, which is realized if the option expires unexercised.
An investor sells 1 DEF Apr 100 put for a premium of 7.75. At what price may DEF be trading for the investor to breakeven?
$107.75
$100
$92.25
$7.75
$92.25
The formula for finding the breakeven point for a put option is the strike price MINUS the premium. This is true for both buyers and sellers of put options. For this question, DEF stock must be trading at $92.25 (100 - 7.75) for the investor to breakeven. Although the investor wants the stock to rise, if it declines by 7.75 points below the strike price, the investor will simply be giving back the amount that was received for selling the option (i.e., the investor will breakeven).
An investor established the following positions:
Long 100 shares of XYZ at $22 per share
Long 1 XYZ Feb 20 put for .75
This investor will profit if XYZ:
Appreciates significantly
Depreciates significantly
Fluctuates
Does not change
Appreciates significantly
The investor purchased the stock at $22 per share and protected (hedged) it by purchasing an XYZ Feb 20 put for a premium of .75. Since the investor has purchased 100 shares at $22, she will profit if the stock price rises significantly. Although buying a put alone is bearish, when it’s paired with a long stock position, it becomes a hedge and doesn’t reflect the investor’s overall sentiment. Another way to look at the position is through the invested amounts. The investor paid $2,200 ($22 x 100 shares) for the stock, but only $75 for the put ($0.75 premium x 100 shares). Since buying stock is bullish and a much larger investment, it dictates the investor’s overall strategy.
A trader sells 100 shares of MNP short at $40 and purchases 1 MNP May 40 call at $3. The trader is:
Guaranteed against a loss until the option expires
Guaranteed a profit until the option expires
Protected from an increase in the market for as long as he’s short the stock
Protected from an increase in the market until the option expires
Protected from an increase in the market until the option expires
The long call will provide protection against a price increase and a loss in the short stock position. If MNP’s price increases, the trader can exercise the call and buy the stock at the $40 strike price, thereby closing (covering) the short position. If the call is exercised, the investor’s loss is limited to $3 per share ($40 short sale - $40 strike price - $3 premium). However, once the call expires and the short position is no longer hedged, the trader will lose money if MNP’s price rises. Although the trader has limited the potential loss for the life of the call option, the option doesn’t guarantee a profit.
An investor sold short 100 shares of QRS stock at $25 per share, and sold one QRS July 25 put at 2. The investor will profit in all of the following situations, EXCEPT:
The price of QRS stock remains at $25 per share.
The price of QRS stock rises to $30 per share.
QRS files for bankruptcy and the stock is now worthless.
The July 25 put expires worthless.
The price of QRS stock rises to $30 per share.
By selling the stock short and writing a put, the investor created a covered put position. The investor is bearish on the stock, but sold the put in order to generate additional income. The investor has taken in a total of $27 per share ($25 in short sale proceeds + $2 premium), which is also the breakeven on the position. As long as the stock remains below the $27 breakeven price, the customer will profit. However, if the price rises above $27, the investor will lose money. In fact, because of the short stock position, the investor’s maximum potential loss is unlimited.
If an individual is short stock and wants protection against an upside move in the market, he should:
Buy a call option
Sell a put option
Buy a put option
Buy a defense stock
Buy a call option
If an individual has sold stock short and wants to protect against an increase in the stock’s price, he should buy a call on the underlying stock. If the stock’s price increases, the individual is able to exercise the call option and buy the stock at the call’s strike price. The call will hedge (protect) the short stock position and limit the individual’s upside losses.
An investor buys 1 XYZ Jan 55 put for a premium of 2.50. What’s the investor’s maximum gain?
$250
$5,250
$5,500
Unlimited
$5,250
The maximum gain for an investor who buys a put option is realized by assuming that the stock declines to zero. In this case, the investor will realize a profit of 55 points, which equates to $5,500 (55 x 100 shares). However, since the investor paid $250 for the put, the actual maximum gain is $5,250 ($5,500 - $250).
