A twisted spread

I was listening to the playback of yesterday's Friday Free Broadcast on Straddles, Spreads, and Combinations, and I realized how hard a guy could make an options question on the Series 7 concerning any of these topics. With that in mind, let's see how twisted a question on option spreads could actually get on the Series 7:

Joe E. Investor buys an ABC Apr 45 put, writing an ABC Apr 50 put. Which of the following is/are true of this position?
I. Joe will profit if the spread widens
II. Joe will profit if ABC drops below 45
III. Joe will establish this position at a net credit to his account
IV. Joe will profit if ABC rises to 50 or above

A. I
B. II, III
C. I, II
D. III, IV

EXPLANATION: okay, let's see what can be eliminated. Widen vs. narrow has to do with whether Joe has a debit or a credit spread. Which put is worth more, the ability to sell stock at $50 or at $45? Obviously, the April 50 put is worth more. Since Joe sold that one, he has a credit spread. Credit = narrow, so eliminate anything with "I" in it. A, and C are gone. And, suddenly "III" is in your answer. And, you just determined that Joe has a credit, so there is no doubt that "III" is in your answer. All you have to do is eliminate "II" or "IV," and you're done. Choice "II" implies that Joe is bearish on ABC. Does that make sense? Is he "long-the-lower-strike"? Yes. So, it does not make sense, because this is a B-U-L-L spread. Choice "II" is eliminated, making the correct answer . . . d

Now quick, what is your middle name?
Sorry--it can get a little confusing, can't it? Notice how I approach every "Roman Numeral" question as if it's a chess game. I'm using logic to eliminate players until I get down to just one remainder. Don't deal with the A-B-C-D structure first. Take each Roman Numeral choice and try to decide if it's in, or if it's out. Then, eliminate the A-B-C-D choices accordingly. This is how you need to approach the Series 7. This is how you take away the upper hand and turn it back on the test itself.

Figure it out

Far too many license exam candidates labor under a misconception about the exams; they think they are supposed to know the answer as soon as they read the question. Unfortunately, for most questions, your job is to figure it out. For example, take a look at the following:

Parents often use zero coupon bonds such as Treasury STRIPS to fund future educational needs. Which of the following is an inaccurate statement of such investments?
A. they lock in a rate of return for the life of the bonds
B. taxation is deferred until maturity
C. their market price volatility is higher compared to interest-paying debt securities
D. they require lower capital commitments

Maybe you already know the answer, but your approach should be to take each choice and try to eliminate it--the choice you can't eliminate must be your answer. Also, it helps to remember that you're eliminating the three TRUE statements in this one. Right? Ok, so do zero coupon bonds lock in a rate of return for the life of the bond? Don't try to picture an imaginary flash card here--ask yourself how zero coupons work. Why are they called "zero coupon" bonds in the first place? Because they make exactly zero coupon payments--therefore, the investor does not reinvest coupon payments at varying rates along the way (reinvestment risk), so I guess the return is "locked in for the life of the bonds." See how much thought it can take to eliminate just one answer choice? Good--two more need to be eliminated, and then we're done. Taxation is deferred until maturity--is that true? Many people have memorized this, but even if so, don't choose this answer yet. Not until you eliminate the other two. Put this one on hold--it looks good, but maybe one of the other choices looks even gooder. What about the "market price volatility," does that make sense? Well, if you remember all that we've said about "duration" and how zero coupons have high "durations," you know it's true. If you don't remember it, figure it out--why would their price be volatile? Probably because there's no cash flow being paid to make the investor feel better about holding the thing. That's true, so we eliminate it, and we sit 50-50 at this point. Either B or D is going to be our answer--getting tired and frustrated? Suck it up, people--you have 260 questions to answer on your Series 7 exam. Okay, Choice D says that zero coupon bonds somehow "require lower capital commitments." And here is where we separate those who will pass the first time and those who might pass on their second or third attempt. The candidates who get frustrated now and start squirming like a little kid have little chance of getting it right. So, take a deep breath and figure it out. Why would the zero coupon require a lower capital commitment? Well, how are they purchased? At a deep discount to the par value--aha! If you can buy $100,000 par value of STRIPS for just $50,000 or $60,000, I'd say that represents a "lower capital commitment," whether I've ever thought of it that way or not. Choice D is eliminated, along with Choice A and Choice C. What's the right answer? The one that is not A, C, or D.

No pain, no gain

This morning I did some tutoring for a gentleman who said something that really opened my eyes. He said, "Sometimes when I think about these straddles and these spreads, it's like a brain freeze, like when you eat ice cream too fast, and it just keeps hurting and hurting . . . until I figure out the question, and then the pain stops."
Wow. See, I knew that options involve extreme mental gymnastics, but I've always thought that stretching the brain in so many different directions felt, you know, good. Not just good, in fact, but really good. I guess I didn't realize that many people experience the very same mental processes as a form of, like, pain. It's similar to the divergent views on physical exercise shared by me and my assistant. This week my assistant took the brave step of accompanying her much younger friend to the gym and the even braver step of letting some "personal fitness expert" assess her "body age" and recommend her weight-loss goal. The fact that the guy added 14 years to her actual age to figure her "body age" and added 10 pounds to her own weight-loss goal would be fodder for a different blog. Point is, no matter what I suggest to her about which machines she might like, or which group classes she might enjoy, she just shakes her head stubbornly and says, "No way--that hurts. Forget it." I've tried to explain that the pain lasts for two or three workouts maximum, but right at that point, I lose the argument. That's the point to her--it hurts! Not just once, not just twice, but three times in a row--hello!
Then again, she does have the computer-generated image of her body at her ideal weight to motivate her, to tempt her toward a seemingly impossible goal, so maybe a little pain is worth it?Sound familiar? My assistant was never an athlete in school; exercise is not her thing. For many candidates, the Series 7 is, similarly, not their thing. They're sales people. They like action, meetings, goals and results. They hate wishy-washy answers and boring, bookworm stuff about convertible debentures trading below parity and debit put spreads narrowing, widening, or whatever the hell a debit put spread is supposed to do. But, you either experience this mental marathon known as the Series 7 as pleasure--the way I do--or you figure out how you're going to deal with the pain. Unlike for my assistant, you don't have the option of not trying. You're already in the game.
Welcome to the Series 7.

Test-Taking Strategy, A Facebook Confession

Facebook has been a great thing for me so far. I can place links to these blogs and other websites, and I can also update my status with "Robert is blogging for his Series 7 students at 5:30 on a cold morning in March," in order to mention my business as often as possible. Another connection to the business comes from all the quizzes that I receive from my old high school friends challenging me to "name that 80's band" or "name that 80's tune." I'm flattered that they think of me as someone to challenge to a quiz, and I also see an opportunity to put my test-taking strategies to the test. The first quiz I took was called "name that 80s band," and I have to admit, I was a little nervous. The first question had me up against the wall--it was a picture of a heavy metal band, and that was really not my forte. I actually thought of my customers at the testing center panicking over the very first question. In honor of them I took a deep breath and said, what are the four choices? We had: Scorpions, Black Sabbath, Dio, Judas Priest. Wow--talk about an advantage! Okay, first, the difficulty level of this facebook-based quiz can not be that freaking high; they would not put a picture of Black Sabbath here unless Ozzy were clearly visible--Sabbath was eliminated. A Judas Priest photo would have to have at least one guy on a motorcycle or wearing motorcycle garb, so Judas Priest was eliminated. Now I'm down to Dio and the Scorpions? What's the name of this quiz? "name that 80's band." Who was a bigger force in the 80's, the Scorpions or Dio? The Scorpions--I win. I now have a comment on my "wall" from the friend who sent me the challenge after seeing the score of 100%. He wrote, "How on earth did you know the name of the guy from the Split Enz?"
Of course, I didn't. I just eliminated the wrong choices and then asked--who was a true "80's band"? And, what would this test want me to say?
I also just got a 100% on a "name that 80's tune" challenge. On the first 9, I simply knew the answer. But I would have only gotten a 90% if I had not used process of elmination on the last one, avoiding "The Bangles" and choosing "Debbie Gibson," not because I have a clue what Debbie Gibson actually sang or looked like, but because "The Bangles" had one or two hits, and the title of the song in the question wasn't one of them.
Always use the multiple choice format to your advantage. Always focus on eliminating wrong answers to improve your odds. Never indicate "single" for your facebook status unless your spouse has a really good sense of humor.

Test-Taking Strategy

Too many Series 7 candidates forget to develop their test taking skills. I do a lot of online 1-on-1 tutoring, and I am often shocked to discover that the client who failed the exam before contacting me is still reading the question, thinking about what the answer must be, and then looking at the four choices to see if it's there. OMG is this a bad approach! The correct answer to the question will often be different from what you want it to be. If you're looking for the word "tranche," the exam might actually want you to call it a "companion bond issued in connection with a collateralized mortgage obligation." My customers routinely report that exam questions will go around in circles to avoid using a standard term. For example, if "inflation risk" is too simple for the test question, it might talk about an investor who is primarily concerned with a general reduction in purchasing power. You have to find the best of the four choices, not necessarily the one you were picturing as the right answer. To deal with this reality, I've always turned the tables on the exams at the testing center. I read the four answer choices first and see what sort of pattern develops right there. More than half the time I know where the question is going based on the four answer choices. But, I take my time because I know how easy it is for one word to change the direction of the question. I now read the words in the question itself carefully, the way I read contracts involving thousands of dollars. Is there a catch? Does it mean what it seems to mean? Is that statement true in all cases? I'll spend 10-30 seconds picking apart the words like this until I know exactly what the question is going for. Then, I start eliminating answer choices. If the question is talking about a bond, I'm eliminating the "preferred stock," choice. If I eliminate one answer choice, I've raised my odds from 25% to 33.3%. Another choice says "bankers acceptance." Hmm. That's a debt security, but based on the remaining three choices, maybe you eliminate the "BA" because it's a short-term/money market security. What if you just eliminated the right answer?
Try not to do that, but remember that you can miss 75 questions on the test and still pass. With many options questions, you'll just add or subtract the premium from the strike price, so you won't need to be so darned cagey and analytical there. But on a huge percentage of questions, you'll find yourself feeling lost and confused, as if you've parachuted into a rainforest somewhere. Don't panic. Step one, read the four answers--where is this going? Step two, read the question carefully, picking apart the words and twisting them around--does it always work that way? Is that true in all cases? Step three, which answers can I eliminate based on something I know? Step four, which choice is the hardest one to eliminate? That, of course, is your answer for that particular question. If you think you might do better on a second go-round, confirm and mark it for review. If you've done your best, confirm it and keep moving. Again, I can't give you insider information or assure you that choosing the longest answer or choosing "C" will help you. But I've taken these exams enough times and gotten ridiculously high scores using the methods I write about in these blogs. I also have stacks of thank-you emails from people who point out that "your method of eliminating the wrong answers was key for me."
Try it. If you have the Kaplan, STC, etc. questions, build a test of 50 or more questions and try the above approach. Try to do it on the unfamiliar questions, though--too many of you are banging out the same darned practice questions again and again. But we'll save that bad habit for another post.

Urban legends from the test prep industry

A customer just sent me an email that is very useful in bringing up the urban legends that surround the world of the Series 7, 6, 65, etc.

Mr. Walker, When I took the series 6 test, my class instructor told us that we should do the math questions last. He says that math questions are a different mind set and should be done after you finish the other word problems. The instructor also said that people generally miss the next 1-3 questions after a math question has been thrown in the mix of questions. Do you find that to the case?

RESPONSE:
Something about the test prep industry attracts pontificators who have no basis for their pontifications. Luckily, their pronouncements are usually harmless, like this one. I wouldn't be surprised if he told you that Procter & Gamble pays dividends in the form of soap and toothpaste, too. Many of these urban legends are repeated for decades, even though maybe 2% are based in truth. Like "when in doubt, choose the longest answer" or "choose Answer C."
There's no science behind any of that. If there were some good science I could use to give you an edge on the exam, I would do so. But, there isn't any science behind it. It's just like investing--we can pretend that our efficient frontier, standard deviation, and sharpe ratio give us scientific precision, or we can admit how far from science we actually operate and just use sound "money management" practices. If the stock is going down, sell it. I don't need a formula--just sell my losers, and hold my winners. I take a similar approach to the exams. I recommend that you simply manage your time wisely. After 30 seconds, if you're still baffled by the question, give it an answer and mark it for review. Keep moving. Maybe you'll have 30 minutes left and 15 questions that were marked for review. Now you can really fight with those 15 hard ones and only change your answer if you're SURE you've seen the light.

Unfortunately, there is no insider information to disseminate on how to pass the exams. Just learn the concepts, use good test-taking skills, and try to keep a cool head at the testing center.