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CFP NOV 2024 Prep > Investments Ch 15 > Flashcards

Investments Ch 15 Flashcards

1
Q

OPTIONS

A

OPTIONS

  • An option is a derivative security, that derives its value from the price behavior of an underlying asset.
  • An option gives the owner the right but not the obligation to buy or
    sell an underlying asset at a specified price for a given period of
    time.
  • Types of Options
  • Puts
  • Calls
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2
Q

OPTIONS: USES

A

OPTIONS: USES

  • Options offer a cost-efficient way to speculate on price movements
    of underlying assets.
  • Options help to hedge or reduce risk exposure of other investments
    or portfolios.
  • Options can be used to reduce transaction costs.
  • Options can be used to reduce or delay the tax exposure of an
    underlying asset.
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3
Q

OPTION TERMINOLOGY

  • Buyer (holder)
  • Seller (writer)
  • Option contract
  • Premium
  • Expiration
  • American vs. European options
A

OPTION TERMINOLOGY

  • Buyer (holder)
  • Seller (writer)
  • Option contract
  • Premium
  • Expiration
  • American vs. European options
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4
Q

OPTION VALUE TERMINOLOGY

  • Intrinsic Value
  • Moneyness
  • At-the-money
  • In-the-money
  • Out-of-the-money
  • Strike Price
  • Time Value
A

OPTION VALUE TERMINOLOGY

  • Intrinsic Value
  • Moneyness
  • At-the-money
  • In-the-money
  • Out-of-the-money
  • Strike Price
  • Time Value
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5
Q

CALL OPTION: EXAMPLE
Olivia wants to purchase Apple stock (current price is $100 per share).
She expects the stock price to increase greatly over the next few
months. She does not have enough cash to purchase the security
today, but she will have the funds in three months. Olivia purchases a call option on Apple stock that allows her to purchase the stock at $100 per share any time within the next 3 months. She pays $20 for the option.

  • What is the strike (exercise) price?
  • What is the option expiration?
  • What will be her profit if the price of Apple stock in three months is:
  • $ 145 per share?
  • $72 per share?
A

CALL OPTION: EXAMPLE
Olivia wants to purchase Apple stock (current price is $100 per share).
She expects the stock price to increase greatly over the next few
months. She does not have enough cash to purchase the security
today, but she will have the funds in three months. Olivia purchases a
call option on Apple stock that allows her to purchase the stock at $100 per share any time within the next 3 months. She pays $20 for the option.

  • What is the strike (exercise) price?
  • What is the option expiration?
  • What will be her profit if the price of Apple stock in three months is:
  • $ 145 per share?
  • $72 per share?
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6
Q

OPTIONS POSITIONS

  • There are two sides to each option contract: a buyer and a seller.
A

OPTIONS POSITIONS

  • There are two sides to each option contract: a buyer and a seller.
  • Therefore, there are four basic positions an investor can take with
    an option contract.
    1. Long Call – buy a call
    2. Long Put – buy a put
    3. Short Call – sell a call
    4. Short Put – sell a put
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7
Q

CALLS

A

CALLS

  • The holder (buyer) has the right to buy the underlying security at a
    specified price over a set period of time from the seller/maker/writer
    in exchange for a fee (premium) paid to the seller/maker/writer.
  • The buyer of the call option benefits if the price of the
    underlying asset goes up.
  • The seller/writer of the call option benefits if the price of the
    underlying assets falls (or stays below the exercise price)
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8
Q

BASIC PAYOFFS: LONG CALL OPTION

A

BASIC PAYOFFS: LONG CALL OPTION

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9
Q

BASIC PAYOFFS: SHORT CALL OPTION

A

BASIC PAYOFFS: SHORT CALL OPTION

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10
Q

HOW CALLS WORK

A

HOW CALLS WORK

  • If the price of the underlying assets goes up:
  • The buyer can exercise the option and buy the asset at the
    strike price.
  • The seller is forced to sell the underlying asset at a price that is
    below market value.
  • If the price of the underlying assets go down:
  • The buyer will not exercise the option and will lose the premium
    (-100% return).
  • The seller will keep the premium received and make a profit.
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11
Q

CALL EXAMPLE

A

CALL EXAMPLE

  • The market price for a share of common stock is $50. A call option to purchase 100 shares of the stock at a strike price of $50 per share may be purchased for $500.
  • If the stock price is $75 at expiration, the owner of the option will
    purchase 100 shares at the strike price.
  • The owner’s profit will be:
  • Profit = [(Market price – Strike price) x 100 Shares] – Call Premium
  • $2,000 = [($75 - $50) x 100 Shares] - $500 premium paid
  • The seller/writer’s loss will be:
  • Loss = [(Strike price – Market price) x 100 Shares] + Call Premium
  • ($2,000) = [($50 - $75) x 100 Shares] +$500
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12
Q

CALL LEVERAGE Using the same example:

  • If the market price of the stock goes up to $75 per share, the buyer
    will purchase 100 shares at the strike price and sell them at the
    higher market price.
A

CALL LEVERAGE Using the same example:

  • If the market price of the stock goes up to $75 per share, the buyer
    will purchase 100 shares at the strike price and sell them at the
    higher market price.
  • The buyer’s profit will be $2,000.
  • The buyer’s total return using the call option will be:
  • Total Return = Profit ÷ Amount invested = $2,000 ÷ $500 = 400%
  • The buyer’s total return directly owning the stock would be:
  • Total Return = Profit ÷ Amount invested = $2,500 ÷ $5,000 = 50%
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13
Q

PUT OPTIONS

A

PUT OPTIONS

  • Allows the holder (buyer) to sell the underlying security at a
    specified price over a set period of time to the seller/writer in
    exchange for the premium.
  • The buyer of the put option benefits if the price of the underlying
    assets goes down.
  • The seller/writer of the put option does not want the price of the
    underlying assets to go down
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14
Q

BASIC PAYOFFS: LONG PUT OPTIONS

A

BASIC PAYOFFS: LONG PUT OPTIONS

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15
Q

BASIC PAYOFFS: SHORT PUT OPTIONS

A

BASIC PAYOFFS: SHORT PUT OPTIONS

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16
Q

HOW PUTS WORK

A

HOW PUTS WORK

  • If the price of the underlying assets goes down:
  • The put owner can buy the asset in the market and then force
    the seller to buy the asset at the strike price, making a profit.
  • The seller will pay a price higher than the market price and will
    own expensive assets or will have to sell them at a loss.
  • If the price of the underlying assets goes up:
  • The put owner will not exercise the option and will lose the
    premium paid.
  • The seller will keep the fee received and make a profit.
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17
Q

PUT EXAMPLE

  • The market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $50.
  • If the stock price falls to $25 per share, the owner will purchase 100
    shares at the market price and force the seller to buy them at the option strike price.
A

PUT EXAMPLE

  • The market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $50.
  • If the stock price falls to $25 per share, the owner will purchase 100
    shares at the market price and force the seller to buy them at the option strike price.
  • The owner’s profit will be:
  • Profit = [(Strike price – Market price) x 100 Shares] – Put Premium
  • $2,000 = [($50 - $25) x 100 Shares] - $500
  • The seller/writer’s loss will be:
  • Loss = [(Market price – Strike price) x 100 Shares] + Put Premium
  • ($2,000) = [($25 - $50) x 100 Shares] + $500
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18
Q

PUTS PROFIT AND LOSS

A

PUTS PROFIT AND LOSS Example:

  • The market price for a share of common stock is $50. A put option
    to sell 100 shares of the stock at a strike price of $50 per share may
    be purchased for $500.
  • If the market price of the stock goes up to $75 per share, the buyer
    will allow the put option to expire worthless.
  • The owner’s loss will be:
  • Loss = Premium
  • Loss = ($500)
  • The seller/writer’s profit will be:
  • Profit = Premium
  • Profit = $500
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19
Q

INTRINSIC VALUE AND TIME VALUE

A

INTRINSIC VALUE AND TIME VALUE

Intrinsic Value
* Intrinsic value of a call: stock price minus the strike price, but not
less than zero
* Intrinsic value of a put: strike price minus the stock price, but not
less than zero

Time Value
* Equals the difference between the premium and the intrinsic value
of the option

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20
Q

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 1

  • An investor buys a call option for $2.00, with a strike price of $50.
  • At a stock price of $51.50, what is the intrinsic value?
  • What is the time value?
A

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 1
* An investor buys a call option for $2.00, with a strike price of $50.

  • At a stock price of $51.50, what is the intrinsic value?
  • Intrinsic value = Stock Price – Strike Price
  • Intrinsic value = $51.50 – $50 = $1.50 per share
  • What is the time value?
  • Premium – intrinsic value = time value
  • $2.00 - $1.50 = $0.50
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21
Q

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 2

  • An investor buys a call option for $2.00, with a strike price of $50.
  • At a stock price of $48, what is the intrinsic value?
  • What is the time value?
A

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 2

  • An investor buys a call option for $2.00, with a strike price of $50.
  • At a stock price of $48, what is the intrinsic value?
  • Intrinsic value = Stock Price – Strike Price
  • Intrinsic value = $48 – $50
  • Intrinsic value = $0 (cannot be less than zero)
  • What is the time value?
  • Premium – intrinsic value = time value
  • $2.00 - $0 = $2.00
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22
Q

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 3

  • An investor buys a put option for $3 with a strike price of $30.
  • At a stock price of $32, what is the intrinsic value?
  • Intrinsic value = Strike price – stock price
  • What is the time value?
A

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 3

  • An investor buys a put option for $3 with a strike price of $30.
  • At a stock price of $32, what is the intrinsic value?
  • Intrinsic value = Strike price – stock price
  • Intrinsic value = $30 - $32
  • Intrinsic value = $0 (cannot be less than zero)
  • What is the time value?
  • Premium – intrinsic value = time value
  • $3.00 - $0 = $3.00
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23
Q

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 4

  • An investor buys a put option for $3 with a strike price of $30.
  • At a stock price of $29, what is the intrinsic value?
  • Intrinsic value = Strike price – stock price
  • What is the time value?
  • Premium – intrinsic value = time value
A

INTRINSIC VALUE AND TIME VALUE: EXAMPLE 4

  • An investor buys a put option for $3 with a strike price of $30.
  • At a stock price of $29, what is the intrinsic value?
  • Intrinsic value = Strike price – stock price
  • Intrinsic value = $30 - $29
  • Intrinsic value = $1.00
  • What is the time value?
  • Premium – intrinsic value = time value
  • $3.00 - $1.00 = $2.00
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24
Q

OPTION ORDERSThere are four types of option orders:

A

OPTION ORDERS

4 types of option orders:

  1. Buy to open
  2. Sell to open
  3. Buy to close
  4. Sell to close
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25
Q

OPTION EXPIRATION

A

OPTION EXPIRATION

  • Options have specific expiration dates, but most exchange-traded
    options have an expiration month in one of the three following
    formats:
  • January Sequential Cycle: Expiration months are January,
    April, July, and October
  • February Sequential Cycle: Expiration months are February,
    May, August, and November
  • March Sequential Cycle: Expiration months are March, June,
    September, and December
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26
Q

TYPES OF OPTIONS

  • Puts and calls may be traded on:
A

TYPES OF OPTIONS

  • Puts and calls may be traded on:
  • Common stocks
  • Stock indexes
  • Exchange traded funds
  • Foreign currencies
  • Debt instruments
  • Commodities and financial futures
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27
Q

OPTION Strategies

  • There are numerous combinations of options and securities. The
    most common are:
A

OPTION STRATEGIES

  • There are numerous combinations of options and securities. The
    most common are:
  • Protective put
  • Covered call
  • Protective call
  • Collar
  • Straddles
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28
Q

PROTECTIVE PUT

A

PROTECTIVE PUT

  • A protective put strategy, sometimes called portfolio insurance, is
    constructed by combining a long position in a security (or portfolio)
    and a long-put option
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29
Q

COVERED CALL

A

COVERED CALL

  • A covered call option involves the sale of a call option combined with the ownership of the underlying stock.
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30
Q

PROTECTIVE CALL

A

PROTECTIVE CALL

  • A protective call strategy involves buying a call option to protect a
    short position on the underlying security. This strategy protects the
    short seller against stock price increases.
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31
Q

COLLAR

A

COLLAR

  • A collar limits gains and losses on an underlying long stock position.
    It combines the downside protection of a long put with the premium
    of a short call option.
32
Q

LONG STRADDLE

A

LONG STRADDLE

  • A long straddle is the combination of a long put and a long call, both
    with the same strike price and expiration.
33
Q

SHORT STRADDLE

A

SHORT STRADDLE

  • Short straddles consist of a combination of a short put option and a
    short call option, both with the same strike price and same
    expiration period.
34
Q

SECURITIES WITH EMBEDDED OPTIONS

  • Financial securities are often issued with an option embedded as
    part of the agreement. Three examples of these embedded options
    are:
A

SECURITIES WITH EMBEDDED OPTIONS

  • Financial securities are often issued with an option embedded as
    part of the agreement. Three examples of these embedded options
    are:
  • Callable bonds
  • Convertible bonds
  • Warrants
35
Q

EMBEDDED OPTIONS: CALLABLE BOND

A

EMBEDDED OPTIONS: CALLABLE BOND

  • The bond issuer may call the bonds at a specific price within a
    specific period of time.
  • Because of the call risk to the investor, callable bonds offer a higher
    expected rate of return.
  • A callable bond has two value components: the bond and the
    embedded option

Non-Callable Bond - Callable Bond = Call Option Value

36
Q

EMBEDDED OPTIONS: CONVERTIBLE BONDS

A

EMBEDDED OPTIONS: CONVERTIBLE BONDS

  • The bondholder may exchange the bond for a stated number of
    shares of the issuing company’s common stock.
  • A convertible bond has two value components: the bond and the
    embedded option.

Convertible Bond - Non-convertible bond = Conversion Option

37
Q
A

EMBEDDED OPTIONS: WARRANTS

  • Companies may issue a bond with warrants attached.
    –A bond with warrants has a lower cost of capital.
  • A warrant is essentially a call option issued by the offering company.
  • Warrants give the holder THE RIGHT , but not the obligation, to purchase shares of the company at a specific price within a specific period of time.
  • Detachable warrants can be separated and traded separately.
  • Warrants tend to be long-term (from two to ten years)
38
Q

OPTION VALUATION

  • The two most common models
A

OPTION VALUATION

  • The two most common models for determining option values are the Black Scholes Option Pricing Model and the Binomial Option Pricing Model. Both models are effective in estimating the value of a call option.
  • The Put-Call Parity Model is used to determine the value of a put
    option from a corresponding call option.
39
Q

BLACK SCHOLES OPTION PRICING MODEL

A

BLACK SCHOLES OPTION PRICING MODEL

This model uses continuous (not discrete) time intervals to determine
the value of a call option. Inputs are:

  • Stock price
  • Exercise price
  • Time to expiration
  • Volatility (standard deviation) of returns
  • Risk-free rate of return
40
Q

PUT-CALL PARITY MODEL

A

PUT-CALL PARITY MODEL

  • The Put-Call Parity Model is used to determine the value of a put
    option from a corresponding call option. The inputs to the model
    include the call option premium, the stock price, and the present
    value of a zero-coupon bond (with face value equal to the strike
    price, discounted at the risk-free rate of return).
41
Q

BINOMIAL OPTION PRICING MODEL

A

BINOMIAL OPTION PRICING MODEL

  • The BOPM estimates the price for a European call option by
    determining the value of a separate portfolio with the same profits
    and losses as the call option being priced.
  • This model traces the discrete movements in the underlying security until expiration. This iterative process is completed using a binomial lattice. Each node is representative of the price of the underlying security at a specific period in time.
42
Q

What is the investor’s strategy for profit if they buy one ABC July 60 call at $3 and buys one ABC July 50 put at $1?

A

Volatility.

Rationale

This strategy is known as a strangle.
The position will be profitable only if the stock moves far enough above the strike price of the call option, or below the strike price of the put option. The investor is therefore not necessarily bearish or bullish, but requires volatility

43
Q

If a farmer buys a wheat put option on futures:

The farmer must deliver the wheat at the specified price.
The farmer must deliver the wheat at the market price.
The farmer must accept delivery on the wheat but will only do so if the price is favorable.
The farmer has the right to assume a short position in the underlying wheat futures at the option strike price.

A

The farmer has the right to assume a short position in the underlying wheat futures at the option strike price.

Rationale

Wheat options are option contracts in which the underlying asset is a wheat futures contract. The holder of a wheat option has the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying wheat futures at the option strike price. This right expires when the option expires after market close on expiration date.

44
Q

A contract that gives its owner the right to sell a specified asset at any time prior to expiration is called:

A futures contract.
A forward contract.
A spot contract.
A put option contract.

A

A put option contract.

Rationale

Options give the holder the right to either buy or sell. A put option gives the holder the right to sell the underlying asset (generally stock) at the strike price.

Futures and forward contracts are designed to make or take delivery at a specified period of time in the future

45
Q

What is the investor’s strategy for profit if they buy 1,000 shares of LMT stock at $71 and also 10 LMT July puts at $2?

Bullish.
Bearish.
Stability.
Volatility.

A

Bullish.

Rationale

The put is to protect the downsides risk.
The investor is bullish because the investor is long the stock.

46
Q

Regarding a short straddle:

The investor is bullish.
The gain potential is unlimited.
The maximum loss is unlimited.
Volatility is expected

A

the maximum loss is unlimited.

Rationale

A short straddle consists of a short put and short call. Gain is limited to the premiums. Losses are unlimited on the call side.

47
Q

Nimoy buys 20 call options on XYZ March 60 for $5 when the price of XYZ is 61. XYZ falls to $40 and remains there through March.
What is Nimoy’s gain or loss?

Gain 29,000.
Gain 30,000.
Loss 9,000.
Loss 10,000.

A

Loss 10,000.

Rationale

The options will expire worthless and Nimoy will lose the premium paid for the options.

5 x 20 options x 100 shares = 10,000 Loss

48
Q

Writing a call option on the S&P 500 Index results in:

A gain if the S&P 500 Index falls.
A loss if the S&P 500 Index falls.
A gain if the S&P 500 Index rises.
Neither a gain nor loss, no matter what happens to the S&P 500 Index.

A

A gain if the S&P 500 Index falls.

Rationale

Writing a call option on the S&P 500 index results in a premium to the writer. The writer loses money if the index increases. The writer’s maximum gain (premium) results if the price of the index decreases

49
Q

Jacinda buys 10 DEF 65 call options for $7 when the price of DEF is $61 Jacinda sells the call options for $16.

What is her gain or loss?

Gain of $900.
Gain of $9,000.
Loss of $900.
Loss of $9,000.

A

Gain of $9,000.

Rationale

Jacinda bought the calls for $7,000.

Remember, 1 option contract represents 100 shares of stock.
10 x 100 = 1000 shares total

Paid Prem to Buy Call <$7,000 >

Receives Prem for the Sell Call &raquo_space; She sold the calls for $16,000.

Therefore, her gain equals $16,000 - $7,000 = $9,000. GAIN

50
Q

Kanye believes that XYZ stock will increase in value. He buys 20 XYZ March 60 call options for $4 when the price of XYZ is $61. If XYZ falls to $55 and stays there through March, what will be Kanye’s gain or loss?

Gain $8,000.
Gain $122,000.
Loss $5,500.
Loss $8,000.

A

Loss $8,000.

Rationale

number of options = 20 x 100 = 2000 options total

Kanye paid $8,000 (2,000 options x $4).

Since its out of the money, let it expire and just lose hte premium paid.

$8,000 is the premium paid and is the maximum loss if the contract expires.

51
Q

An investor purchased a put option with a strike price of 82 and wants to combine it with another option with on the same stock with the same expiration date to create a long strangle position.

Which of the following actions should the investor take?

Buy a call option with a strike price higher than 82.
Buy a call option with a strike price lower than 82.
Sell a call option with a strike price of 82.
Sell a call option with a strike price higher than 82

A

Buy a call option with a strike price higher than 82.

Rationale

A long strangle consists of a long put and a long call option with a higher strike price. As the investor already has a long put with a strike price of 82, she needs to add a long put with a strike price higher than 82.

52
Q

For a call option contract, the price at which the option holder can buy the underlying security is called?

Premium.
Exercise price.
Intrinsic value.
Long price.

A

Exercise price.

Rationale

The price at which a call option holder buys the underlying stock is called the exercise price or the strike price.

53
Q

A writer of a call option:

Bought a “long” position in a futures contract.
Sold a call option.
Bought a call option.
Exercised a call option.

A

Sold a call option.

Rationale

The writer of a call option is the seller of the option and receiver of the option premium.

54
Q

Which of the following option positions represents the most risk to an investor?

A long put.
A long straddle.
A long call.
A short straddle

A

A short straddle.
Rationale

A short straddle is a short call combined with a short put on the same underlying security, each having the same strike price and exercise month. With a short straddle, the investor makes money if the stock price remains constant. The investor can lose if the stock price decreases or increases. The larger the price change, the larger the loss. If the market price of the underlying stock increases, the short call can be exercised against the investor. Because the stock price can increase without limit, the short straddle has unlimited loss potential.

55
Q

An “at the money call:”

Has intrinsic value = 0.
Is where the stock price > strike price.
Is where the stock price < strike price.
Has a time value = 0

A

Has intrinsic value = 0.

Rationale

An “at the money call” is strike price equal to the market value, which is an intrinsic value of zero.

56
Q

A put option is available on the stock of Rally Corporation. The exercise price is $65. The put option price is $1.
Rally stock is currently selling for $70 per share.

What is the “intrinsic value” of the put option?
$0.
$4.
$5.
$9

A

$0.

Rationale

The intrinsic value is the minimum value an option will trade for and equals the strike price minus the FMV of the stock for a put option.

In this case, the intrinsic value equals $0 ($65 - $70) – it cannot be less than zero.

The intrinsic value is not influenced/impacted by the option price.

57
Q

Which of the following positions has the greater risk for investors?

Long call.
Selling a covered call.
Selling a covered put.
Shorting a stock.

A

Shorting a stock.

Rationale

The maximum loss for a long call is the premium paid.

The risk for a covered call is to lose the stock, which is a loss of upside potential.

A covered put involves writing a put for a stock that has been sold short. The put premium offsets some of the downside risk.

The short sale of a stock is the riskiest position since the short seller must repurchase the stock in the open market if the stock price increases

58
Q

Jace owns a convertible bond with a $1,000 face value that can be exchanged for 25 shares of WUF stock, which is trading at $50 per share. The conversion ratio equals:

1.25.
20.
25.
40

A

25.

Rationale

The conversion ratio= the number of shares of common stock that the bondholder will receive if the bond is converted.

59
Q

Jace owns a convertible bond with a $1,000 face value that can be exchanged for 25 shares of WUF stock, which is trading at $50 per share. The conversion price equals:

$20.
$25.
$40.
$50.

A

$40.

Rationale

The conversion price = the par value of the bond ($1,000) divided by the conversion ratio (25), which equals $40.
par value $1,000
Conversion price = —— ———– = ————- = $40
conversion ratio 25

60
Q

Rascal has entered into a contract to buy 100 shares of Rally stock for $40 per share anytime over the next six months. He has a:

Long position in a call option.
Short position in a call option.
Long position in a futures contract.
Short position in a put option.

A

Long position in a call option.

Rationale

A call option gives the holder the right to purchase the underlying security at a specific price within a specific period of time.

61
Q

An investor buys 100 shares of XYZ stock for $40 and simultaneously writes 1 XYZ November 40 call at $3. If the investor closes both positions three months later when the XYZ is trading at $45 and the November calls are at $6, what is the result?

$200 profit.
$300 profit.
$400 profit.
$500 profit.

A

200 profit.

Rationale

Stock position 100 x ($45-$40) = $500

Option position ($6-$3) x 100 = ($300)

$500 - $300 = $200 profit

62
Q

Clarissa holds a concentrated position in XYZ stock, which she purchased 15 years ago for $6 per share. The price of XYZ stock is currently at $100 per share, and Clarissa is happy with the gain that she has achieved. She realizes that it is a good idea to diversify her portfolio, but selling all of the stock in the current year will result in a large tax burden.

Which of the following strategies would allow Clarissa to sell some of the shares this year, and delay selling some of the shares until next year to help ease the tax burden, but will lock in her sale price within a reasonable range of the current price?

A straddle.
A spread.
A collar.
A short sale.

A

A collar.

Rationale

A collar strategy involves the simultaneous purchase of a put option and sale of a call option, with the same expiration but different strike price.

For example, Clarissa might be able to purchase a put option with a strike price of $90 that expires next year in February, by paying a premium of $4.

At the same time, she may be able to sell a call option with a strike price of $105 that expires in February of next year, and receive a premium of $4. T

his would be called a “zero cost collar” since the premium she paid for the put is exactly offset by the premium she received for writing the call.

In February of next year, if the price of XYZ stock has risen above $105, the holder will exercise and Clarissa will sell at $105.
If the price falls below $90, Clarissa will exercise her put option and sell at $90. She has “collared” her sale price between $90 and $105 for the next tax year.

63
Q

An investor buys 1 ZZZ Dec 95 call at $5. When ZZZ increases to 99, the call is exercised and the stock is immediately sold. What is the result?

A profit of $100.
A profit of $400.
A loss of $100.
A loss of $400

A

A loss of $100.

Rationale

($4 gain from stock price x 100 shares) - ($5 premium paid x 100 shares) = Loss of $100

64
Q

Gerry expects the market to rise. Which of the following option strategies should he follow:

  1. Long call
  2. Long put
  3. Short call
  4. Short put
A

1 and 4.

Rationale

Long a call (buy), short a put (sell)

65
Q

An investor believes there is an equal chance of GJR stock increasing or decreasing in price significantly. Which of the following option strategies is the investor most likely to use?

Protective put.
Long strangle.
Short straddle.
Strip.

A

Long strangle.

Rationale

A long strangle will profit if the stock moves significantly higher or lower. A movement in either direction will be equally profitable. A strip is appropriate when an investor is more bearish.

66
Q

The conversion ratio of a convertible bond equals:

The market value of the bond divided by the conversion price

The number of shares of common stock that the bondholder will receive if the bond is converted.

The value of the common stock times the conversion price.

None of the above

A

The number of shares of common stock that the bondholder will receive if the bond is converted.

Rationale

Option b is the definition of conversion ratio.

67
Q

Rascal has entered into a contract to buy 100 shares of Rally stock for $40 per share anytime over the next six months.

He has a:
Long position in a call option.
Short position in a call option.
Long position in a futures contract.
Short position in a put option.

A

Long position in a call option.
Rationale

A call option gives the holder the right to purchase the underlying security at a specific price within a specific period of time

68
Q

With the same dollar investment, which of the following strategies can cause an investor to experience the greatest loss?

Selling a naked put option.
B. Selling a naked call option.
C. Writing a covered call.
D. Buying a call option.

A

The correct answer is B.

Naked call writing (selling) is the most dangerous position in the described selection.
If the market price of a stock moves against a put writer, it can fall to zero and that’s the end of it.
If it moves against a call writer, the sky is the limit as to how high the price could go.

69
Q

A client with a large, well-diversified common stock portfolio expresses concern about a possible market decline. However, he/she does NOT want to incur the cost of selling a portion of their holdings NOR the risk of mistiming the market. A possible strategy for him/her would be:

A. Buy an index call option.
B. Sell an index call option.
C. Buy an index put option.
D. Sell an index put option.
A

the correct answer is C. . Buy an index put option.

A put option index that closely mirrors the client’s portfolio will allow for minimization of loss in the event of market decline.

70
Q

Which option transaction would an Investor make when they expect the market to rise & are willing to accept a higher level of risk?

A. Buy Put
B. Sell Call
C. Sell Put
D. Buy Call
A

The correct answer is C. Sell Put

To help answer this question, we will utilize the four square chart.

In a bull market, or rising market, there are two options investors will look towards; Buying Calls, or Selling Puts.

An investor that buys a call decides when they should exercise the call, typically during an upswing where they can turn around and sell the stock for a profit. Investor pays the premium, pays for the stock if they exercise the option. They either hold the stock or sell it above the strike price for a profit. Should the market take a down turn, they hold the option to expiration.

An investor that sells a put (is the writer of the put), does not have a say when it comes to exercising the option. The buyer, or holder, of the put option will chose to exercise or let it expire. Should they exercise, the writer of the option is required to fulfill the option, meaning they must buy the stock “put” to them at the strike price. Now the writer owns the stock in a down market and if they sell the stock, it will be at a loss. They could chose to hold the stock in hopes of a rebound but they are out the purchase price of the stock. The upside, the market remains steady and the option is not exercised and the writer keeps the premium received. This makes this choice a riskier position than purchasing a call in an up market.

71
Q

You purchase one put contract and pay a $3 premium that allows you to sell the stock at $50. The stock is currently trading at $48.
What is the intrinsic value of the situation you’re in?

A

correct answer is D.

Intrinsic Value of Put = Strike Price - Stock Price,

therefore IV = 50 - 48 = 2

72
Q

Investor expects market to decline & willing to accept high risk.

A. Buy Put
B. Sell Call
C. Sell Put
D. Buy Call
A

The correct answer is B.

B. Sell Call

73
Q

Put in the money

Stock Price > Strike Price
Stock Price < Strike Price
A

Stock Price < Strike Price

74
Q

Mary wrote a 40 call on ABC stock for $275. She does not own any shares of ABC. Mary has

limited her losses to $275.
unlimited loss potential.
limited her gains to $275.
unlimited profit potential.

I and IV only
II and III only
I and III only
II and IV only
A

The correct answer is B.

Mary wrote a call with a strike price of 40, and collected $275 in premiums. Best case scenario, Mary keeps the premium and the option expires.

If the purchaser does exercises the call, Mary will need to buy the stock in the open market and sell it at the strike prices of 40. If the option is exercised, that means the price of the stock is trading above $40 a share, so Mary’s purchase of the stock at a higher price than the strike price and will result in a loss immediately when the option is fulfilled. Since there is no cap on how high the stock could go, there is unlimited loss poten

75
Q

Which of the following are characteristics of short selling?

I. borrowing shares of stock from a brokerage firm or other investors

II. selling shares of stock you do not own

III. betting the stock price will increase

IV. limiting losses per share to the price at which the stock was sold

A     I, II and IV only
B  III and IV only
C   I and II only 
D  I, II and III only
A

The correct answer is C.

Selling short, you want the stock to decrease in price, not increase.

Investors sell on the front end and buy back at a later time.

76
Q
A

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