Unit 5

Question 1

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Question 1

What is intrinsic value of an option?

Answer 1

The intrinsic value of both call and put options is the difference between the underlying stock’s price and the strike price. If the calculated value is negative, the intrinsic value is zero. In other words, intrinsic value only measures the profit as determined by the difference between the option’s strike price and market price.

However, other factors such as extrinsic value can affect the value of an option and its resulting premium. It takes into account other external factors such as how much time is remaining until expiration.

If an option has no intrinsic value, meaning the strike price and the market price are equal, it might still have extrinsic value if there’s enough time left before expiration to make a profit.

As a result, the amount of time value that an option has can impact an option’s premium. Both intrinsic value and extrinsic value combine to make up the total value of an option’s price.

Question 2

The Securities Act of 1933 exempts all of the following securities from registration except:
A) savings and loan issues.
B) public real estate investment trusts (REITs).
C) U.S. government issues.
D) municipal issues.

Answer 2

(B) REITs

Though some REITs trade on exchanges and others may not, all public REITs are nonexempt securities which must be registered with the Securities and Exchange Commission (SEC).

Question 3

A March 30 call purchased at 3 has expired without being exercised. The owner of the call

Answer 3

The owner (buyer) of the call would have paid 3 ($300) for the contract. If the contract expires unexercised, the owner loses the $300 premium paid.

Question 4

All of the following terms and phrases are associated with the sell side of an option contract except
A) receives the premium.
B) has an obligation.
C) writes the contract.
D) has a right.

Answer 4

(D)
The buyer of the contract pays the premium and loses it if the contract expires worthless. The seller receives the premium and keeps it if the contract expires unexercised. The buyer has a right to exercise the contract. The seller has an obligation if the buyer decides to exercise. Buyer, holder, owner, and long all mean the same thing. Seller, short, and writer all mean the same thing.

Question 5

With CDT stock at 42, a September 40 call trading at 3 is

Answer 5

When a calls strike price is lower than the underlying stocks value, the call contract is in the money. The amount it is in the money is the difference between the 2—2 points (42 – 40).

Question 6

An investor is long a January 30 call at 2. Maximum gain for this position is

Answer 6

For a long call option, the maximum gain potential is unlimited because the underlying stock can rise to some unlimited number—in theory, infinity. As the stock price rises, so too would the value of the call.

Question 7

Which of the following oil and gas direct participation programs might be considered the riskiest?
A) Raw land
B) Combined exploratory and income
C) Exploratory
D) Income

Answer 7

Exploratory programs, also called wildcatting programs, are those that look for resources near existing producing wells in the hopes of finding more deposits. These are considered riskiest of the oil and gas programs—exploratory, income or a combination of the two. Raw land is a type of real estate program, not an oil and gas program.

Question 8

Exploratory oil and gas DPP programs are also know by what name?

Answer 8

Wildcatting programs (those that look for resources near existing producing wells in hops of finding more deposits)

Question 9

An investor is short a January 30 call at 5. Breakeven is

Answer 9

Breakeven for a call (long or short) is premium (5) plus strike price (30). In this case 35 points. Because short calls are bearish, the investor who is short the call needs the stock to be below the BE (35), while the investor who is long the call wants it to be above the breakeven point (35) to make a profit. Always remember that BE for both parties to the contract is always the same number.

Question 10

When a limited partnership is liquidated (dissolved), the priority of payments to settle accounts are made from first to last in which order?

1) General partners
2) Limited partners
3) Secured creditors
4) General creditors

Answer 10

3, 4, 2, 1

Creditors are paid first in a liquidation, with priority given to the secured lenders before general lenders; limited partners are paid first of the partners, with general partners last to be paid.

Question 11

An investor sells short 1 MJS June 55 put at 2. The current market value of LMN is 56. The investor’s maximum loss potential is

Answer 11

$5,300

Put sellers are bullish. Therefore, the maximum risk is if the stock falls to 0. The maximum potential loss, therefore, is the strike price less the premium received for the put (55 − 2 = 53). The maximum loss per contract is $5,300. The current market value of the stock at the time the put was sold short is of no consequence.

Question 12

The buyer of an option contract can be known as all of the following except:
Long party, holder, writer, owner

Answer 12

Writers. Writers are those who sell the contract.

Options buyers (purchasers) can be referred to as the owner, holder, or the party who is long the contract.

Question 13

For ETFs, the phrase “tax efficiency” can best be described as?

Answer 13

Usually, for ETFs, there are no tax consequences for investors until the shares are sold.

The single greatest advantage associated with ETFs is the fact that while they can pass on capital gains from time to time, creating tax consequences in that year, they rarely do. Therefore, there would be no expected tax consequences until the shares are sold. This is the tax efficiency generally associated with ETFs.

Question 14

For ETFs, the phrase “tax efficiency” can best be described as?

Answer 14

Usually, for ETFs, there are no tax consequences for investors until the shares are sold.

The single greatest advantage associated with ETFs is the fact that while they can pass on capital gains from time to time, creating tax consequences in that year, they rarely do. Therefore, there would be no expected tax consequences until the shares are sold. This is the tax efficiency generally associated with ETFs.

Question 15

On a short put, when the premium equals the intrinsic value, the put is

A) at its breakeven point
B) past expiration.
C) out of the money
D) at parity

Answer 15

(D) at parity

All puts are in the money when the market price is below the strike price. They are out of the money when the market price is above the strike price. They at the money when the market price equals the strike price. They are at parity when the premium equals the intrinsic value.

Question 16

Puts are considered in the money when?
When are they out of the money?

Answer 16

All puts (short long) are in the money when the market price is below the strike price.

They are out of the money when the market price is above the strike price.

Question 17

When are puts considered at the money?

Answer 17

They at the money when the market price equals the strike price.

Question 18

When are puts at parity?

Answer 18

They are at parity when the premium equals the intrinsic value.

Question 19

An investor shorts 4 HAPY January 70 puts at a premium of 5 each when the market price of HAPY is 67. What is the investor’s maximum potential loss?

Answer 19

When short a put, the risk is that the stock falls. The maximum risk occurs if the stock falls to zero. The maximum potential loss therefore is the strike price less the premium received for the put (70 – 5 = 65). The maximum loss per contract is $6,500, but with four contracts, the potential loss is $26,000. Note that the market price of the stock at the time of the sale of the put is of no consequence.

Question 20

An investor is long 1 July 40 call at 2 (tell everything)

Answer 20

An investor who is long 1 July 40 call at 2 has paid $200 premium to purchase the call. Owning the call, the investor has the right to exercise the contract to purchase 100 shares of stock at the strike price ($40).

Question 21

The allowable deduction for equipment used in an oil and gas direct participation program is taken as

Answer 21

Tangibles such as equipment that will have some salvage value at the end of the program can be depreciated. The depreciation is an allowable deduction taken over the life of the program.

Question 22

The four basic options transactions are

Answer 22

long calls, short calls, long puts, short puts.

The four basic options transactions are either buying or selling calls and puts. Hence, long calls, short calls, long puts, short puts. Remember that in options terminology, selling, shorting and writing all represent the same transaction.

Question 23

A stock currently has a market value of $75 per share. If a put option on the stock has an exercise price of $60, the put option is

Answer 23

out of the money

This put option has a zero intrinsic value and is therefore out of the money by the 15 points difference by which the market price exceeds the strike price. A put option has intrinsic value or is in the money when the current market price of the underlying asset is less than the exercise price (in this example, $60).

Question 24

At expiration what do put buyers want? What do put sellers want?

Answer 24

At expiration, put buyers (like call buyers) want the contracts to have intrinsic value and, therefore, to be in the money. Put writers (like call writers) want the contracts to be either at or out of the money and, therefore, have no intrinsic value.

Question 25

At expiration what do call buyers want? What do put sellers want?

Answer 25

At expiration, call buyers (like put buyers) want the contracts to have intrinsic value and, therefore, to be in the money. call writers (like put writers) want the contracts to be either at or out of the money and, therefore, have no intrinsic value.

Question 26

At expiration what do call buyers want? What do put sellers want?

Answer 26

At expiration, call buyers (like put buyers) want the contracts to have intrinsic value and, therefore, to be in the money. call writers (like put writers) want the contracts to be either at or out of the money and, therefore, have no intrinsic value.

Question 27

Which of the following describes the position in a call option on a stock with a strike price of 20, a premium of 7, and a current market of 26?

A) At parity
B) In the money
C) At the money
D) Out of the money

Answer 27

In this case, the strike price is less than the current market value, so a call option would be in the money by the difference between the strike price and the market price (6 points, in this case). At the money means the strike price and the market price are the same; at parity means the premium equals the intrinsic value.

Question 28

A client has established a long put position. The contract will have intrinsic value when the price of the underlying stock is

Answer 28

less than the exercise price(strike price).

Put buyers are bearish and want the underlying stock to fall in value. Puts give the owner the right to sell at the contract’s exercise (strike) price. Therefore, the put contract will pick up intrinsic value if the price of the underlying stock falls below the contract’s strike price. The long put position will become profitable if the stock falls below the strike by more than the amount of the premium paid.

Question 29

Limited partnerships sold through private placements involve

Answer 29

a small group of investors, each contributing a large sum.

Limited partnerships sold through private placements generally consist of a small group of accredited investors, each contributing a large sum to the partnership.

Question 30

Regarding oil and gas DPPs, tangible drilling costs are associated with items that

A) have no salvage value at the end of the program.
B) have some salvage value at the end of the program.
C) can be depreciated.
D) cannot be depreciated.

Answer 30

(B&C)

Costs for items that will have some salvage value at the end of the program are considered tangible drilling costs. These items, such as equipment, can be depreciated and written off over the life of the program.

Question 31

Listed options can be exercised by

A) the holder after the expiration date.
B) the holder from the time of purchase until they expire.
C) the writer from the time of purchase until they expire.
D) the writer after the expiration date.

Answer 31

Listed options can be exercised by the holder (owner, buyer, party who is long) from the time of purchase until they expire. Writers (sellers, party who is short) cannot exercise contracts. Instead, writers are assigned when the owners of the contracts exercise them.

Question 32

Partners in direct participation leasing programs can receive write-offs for all the following except

A) depreciation.
B) operating expenses.
C) depletion.
D) interest expenses.

Answer 32

Write-offs (deductions) associated with leasing programs are those taken for operating expenses, depreciation of the equipment owned and leased, and interest costs on the loans to purchase the equipment. Depletion, however, is a deduction associated with natural resources programs, such as oil and gas.

Question 33

Which of the following option positions would offer a full hedge to a short stock position?

A) Long put
B) Long call
C) Short put
D) Short call

Answer 33

(B) Long call

The best way to hedge a short stock position is with a long call.

Question 34

The seller of a call has

Answer 34

the obligation to sell the stock.

unlimited risk

The buyer of the call has the right to buy the stock. The seller of the call has the obligation to sell the stock.

Question 35

ABC Corporation’s stock is trading at $35. A client has purchased a 50 call. The option’s current value is made up of

Answer 35

In this case, the option has no fundamental value since an investor could acquire stock at $35 in the market place, while the option provides the opportunity to purchase shares at $50. The option is out of the money, which means its total premium is made up of time value.

Question 36

Your customer has a large cash position and is interested in purchasing shares of Brick n’ Mortar Stores stock (ticker: BMS) if it drops to $20 a share. The stock is currently trading at $23 a share. They are curious to know if there is a way to use options to generate some extra income and buy the shares if the stock drops. You might suggest

Answer 36

writing covered puts on BMS stock that are currently out of the money.

Writing the puts would generate premium income. If the stock declines in value and the option is exercised, the customer will buy the stock at a price lower than where the market is at this moment. The short calls would force him to sell the shares if exercised. Buying out-of-the-money calls costs money and the strike price would be higher than the market. The buy stop does not generate income.

Question 37

The holder of an in-the-money option contract gives a do not exercise instruction (notice) to your broker-dealer. This notice is what?

Answer 37

is used to avoid automatic exercise at expiration.

Options that are at least $0.01 in-the-money at expiration will be automatically exercised unless a do not exercise instruction or notice is given. If the holder of such a contract does not want the automatic exercise to occur, this notice must be given before expiration.

Question 38

An option contract having no intrinsic value at expiration will likely be

Answer 38

With no intrinsic value at expiration, an option contract is worthless. Therefore, the owners of these contracts would most likely allow them to expire rather than exercise them.

Question 39

Let’s say a call option’s strike price is $15, and the underlying stock’s market price is $25 per share. What is the intrinsic value?

Answer 39

The intrinsic value of the call option is $10 ($25 minus $15).

If the option premium paid at the onset of the trade were $2, the total profit would be $8 if the intrinsic value was $10 at expiry.

Question 40

let’s say an investor purchases a put option with a strike price of $20 for a $5 premium when the underlying stock was trading at $16 per share. What is the intrinsic value?

Answer 40

The intrinsic value of the put option is the $20 strike price less the $16 stock price, or $4 in-the-money.

An intrinsic value of $4 at expiry combined with the premium paid of $5 means the investor has a loss despite the option being in-the-money.