Economic Indicators

Bond yields would be expected to rise due to a drop in which of the following indicators?
A. prime rate
B. unemployment claims
C. GDP
D. building permits

EXPLANATION: remember that bond yields rise as economic activity increases. So, a drop in GDP is associated with falling yields, as is a drop in building permits. If the prime rate is dropping, we would assume other interest rates are dropping. But, when unemployment claims are dropping, that means people are going back to work, which is the only indicator that might point toward an increase in economic activity.

ANSWER: B

Bond yields

Let's look at a possible exam question on everybody's favorite topic: bond yields.

S&P just downgraded a corporate bond, pushing the bond’s yield
A. down
B. sideways
C. up
D. in a bond-ladder direction

EXPLANATION: if the rating goes down, so does the “quality,” which means the price falls. And, when the price falls, the yield rises. Would you pay as much for a junk bond as you'd pay for a Treasury bond? Not a chance--the riskier bonds cost less and yield more.



ANSWER: C

MSRB Rules

It's Friday morning and, as usual, I am visiting the FINRA website to see which firms are being hassled currently for rule violations. I always enjoy seeing some of your testable points in action, and this morning I see that a firm is being fined for failing to deliver official statements with new issues of municipal securities. As always, this is not a dig on the particular firm--there are so many ways to violate MSRB and FINRA rules that it would only surprise me if a well known firm did not find itself in hot water every couple of months.

You can read the news release at:
http://www.finra.org/Newsroom/NewsReleases/2009/P118457

Discretionary Authorization

Which of the following orders would require written discretionary authorization?
A. Buy 1,000 shares of XYZ today
B. Buy 1,000 shares of XYZ when the price is right
C. Buy as many shares of XYZ as you think I should buy when the price is right
D. All of the choices given

ANSWER: C
WHY: written discretionary authorization for the account is only required if the customer lets the rep choose the Action (buy/sell), the Asset (which stock?), or the Amount (# of shares). If the rep is merely choosing the time/price at which to enter an order where the customer has already named the 3 A's . . . that doesn't require written discretionary authorization. So any rep can choose time/price, but only those with discretionary authorization over the account can choose ANY of the three A's.

The Dreaded Yield Spread

Let's enjoy a difficult practice question on a Saturday, shall we?

One of your customers, Joe Myers, calls to inquire about something he heard but did not quite understand on CNBC. "Why is the price differential between low-risk and high-risk debt securities smaller than usual?" he asks. You would respond
A. turn off the TV and get a life, Joe
B. it means investors are confident in the overall economy
C. it means investors are not insisting on safety to the same degree
D. both B and C

ANSWER: D
EXPLANATION: right now, investors will accept tiny yields on Tbills, Tnotes, and Tbonds and won't touch junk bonds (corporate and muni) unless the bonds offer ridiculously high rates. The "yield spread" has widened in other words because investors are freaking out. For a few days, investors dumped everything and ran to Treasuries, accepting NEGATIVE yields on Tbills. Seriously--people were giving Uncle Sam $1,005 in order to receive $1,000 in 3 months, essentially, which is known in financial textbooks as "really stupid." Now, if the difference in yields between ultrasafe Treasuries and junk bonds narrows, that expresses confidence. Investors aren't so worried about companies defaulting on them and will pay more for the bonds/accept lower yields.

Straddles

Multiple options include the spreads we just discussed and also the straddles we're about to discuss. While I'll allow that spreads can be difficult, I simply will not accept any whining over straddles. If you can understand the long call and the long put, you can understand the so-called "long straddle." You just have to put both positions together and put on your thinking cap.
No--we said no whining.
Let's say that GE is about to announce whether it will continue as a conglommerate or spin itself off into 5 separate units. This news could send the stock way up or way down in a hurry. Since you're only willing to bet that it will move--not on the direction--you need to buy both a call and a put with the same strike price. If the stock trades at $30 (I wish), you buy a GE Apr 30 call and a GE Apr 30 put. Unfortunately, both options are at-the-money and, therefore, hugely expensive. Maybe you pay 2 for the call and 2.25 for the put. If so, you just paid $4.25 per share for the "long straddle." Now, let's keep those thinking caps on. If you pay $4.25 for an options position, doesn't that position have to move in your favor by $4.25 to break even, and by more than $4.25 to profit?
Yes, and yes.
So, if the stock goes up or down by $4.25, the investor breaks even. If it goes up or down by more than $4.25, the investor profits. What if GE closes at $37 on the expiration Friday in April? This investor would profit. He would make the difference between $37 and his breakeven at $34.25, which is $275 per contract. If the stock falls anywhere between $34.25 and $25.75, he loses some money. If the stock finishes right at $30, both options expire, and he loses the full $4.25 per share in a hurry.
What about the guy who sells the GE Apr 30 call and the GE Apr 30 put--what's this guy thinking? He's thinking that the stock will sit still, or at least will never move by $4.25. If the stock moves less than $4.25 in either direction, he makes a profit. And if the stock stays right at $30, both options would expire, and he'd make $425 per contract without lifting a finger. How much could this guy lose? Everything. He could lose if the stock drops big-time, and if the stock rises, the loss is unlimited, since he essentially wrote a naked call. How high could GE rise? Hypothetically, it's unlimited, which is why I don't write straddles any more than I engage in free-form rock climbing, hang gliding, or betting on the Chicago Cubs.
So, all you need to do is be able to first identify a straddle. To do that, just remember that everything is the same about the two positions except that one is a call and one is a put. In other words, the following is a straddle:

Long ABC Jun 50 call
Long ABC Jun 50 put

But, this next one is a spread:

Long ABC Jun 50 call
Short ABC Jun 55 call

Or, if the question gives you the premiums and wants to know the breakeven points, just add both premiums and subtract both premiums to/from the strike price. In other words, if the straddle looks like this:

Long ABC Jun 50 call @2
Long ABC Jun 50 put @2.25

Just take $4.25 and add it to 50, then subtract it from 50. The breakevens are at $54.25 and at $45.75.

Are we having fun yet?
Oh. Guess it's just me. Anyway, if you run into a "hard" question on straddles, submit it by email or through the comments section.

Spreads

Spreads can stretch the brain in directions it doesn't really want to go for many Series 7 candidates. Of course, we've already discussed how some people view this stretching as a pleasurable activity, so let's focus on the other 95% who would rather pound bamboo chutes under their fingernails than decipher a debit call spread. First, what the heck is a "spread"? A spread is simply the purchase of one option and the sale of another. Rather than selling an ABC Aug 50 call by itself, which would leave the writer exposed to unlimited loss, the investor also purchases an ABC Aug 60 call. He'll collect more writing the Aug 50 call than he'll spend on the Aug 60 call, so we call it a "credit spread" or a "credit call spread." Of course, what I just wrote baffles and annoys most candidates--they don't see any premiums attached, so how can I just, like, know that the Aug 50 call is worth more? Because an ABC Aug 50 call is a contract giving someone the right to buy ABC common stock at 50, which is better than the right to buy the stock at 60. For intrinsic value, think from the buyer's perspective. A "call" lets someone buy stock--they want to buy low, so the lower the call's strike price, the more valuable it is. Once you can see that the Aug 50 call is worth more than the Aug 60 call, you just have to remember that if the individual buys the Aug 50 and sells the Aug 60, he'll start out with a debit--why? He had to have paid more for the Aug 50 call than he received selling the Aug 60 call. So, we call it a "debit spread."
To profit, a credit spread needs to "narrow" or "expire." A debit spread investor wants and needs the spread to "widen" or for the options to be "exercised."
So, is the following a debit or a credit spread:

Buy 1 ABC Jan 50 call
Sell 1 ABC Jan 45 call

1. Which option is worth more? The right to buy the stock for $45 or for $50? The ABC Jan 45 call is worth more than the ABC Jan 50 call
2. Did the investor buy or sell that option? The investor sold the more valuable option.
3. Therefore, this is a credit spread

What about this one:

Buy 1 ABC Jan 50 put
Sell 1 ABC Jan 45 put

1. Which option is worth more? The right to sell stock for $50 or for $45? The right to sell stock for $50 is more valuable.
2. Did the investor buy or sell that option? The investor bought that option.
3. Therefore, this is a debit spread

I know, I know. Many of you friggin' hate this stuff more than you friggin' hate reading the instructions that came with your I-POD. That's normal. Unfortunately, the Series 7 is anything but, so keep grinding it out with these spreads. And feel free to submit your questions through the comments field.