Another options question

Juan buys 100 ABC @80 then sells 1 ABC Nov 80 call @2 and 1 ABC Nov 80 put @1.50. His maximum gain is, therefore

A. $8,000
B. $350
C. zero
D. $200

EXPLANATION: can't imagine why Juan--or anyone--would establish this weird position. But, if the stock goes up at all, it gets called away at $80. If so, he would only make the premiums of $350.



ANSWER: b

Time Value Again

A "call" option is the right to buy a stock at a set price known as the "strike price" or "exercise price." If the stock is worth $3 more than that strike/exercise price, the call option is worth that $3 difference, always. That's the intrinsic value of being able to save $3 when buying that stock. But, the option would be worth more than just that $3, as long as there is still some time left. If there is still a month to go, an ABC Aug 50 call might be trading for $4 a share, when ABC common stock is only trading for $53. The intrinsic value is $3, but there is still time for ABC to keep rising. If you want to buy this call option, you pay $4 a share, which is $3 of intrinsic value and $1 of time value. If the stock stops moving at $53, that time value will begin to evaporate quickly, as time runs out on the option. If you buy this option for $4 today, you can only win if the stock rises, and rises fast enough to outweigh the negative effects of time.

Let's work with the concept of time value in a rather annoying practice question:

Which option below has the most time value if ABC currently trades at $51 a share?
A. ABC Aug 50 call @$1.50
B. ABC Oct 50 call @2.50
C. ABC Oct 50 put @2.00
D. ABC Oct 55 put @4.25

EXPLANATION: step one, find the intrinsic value in each option and subtract that out of the premium. An Aug 50 call @1.50 has $1 of intrinsic value, 50 cents of time value. An Oct 50 call (which HAS to have more time value on it than the Aug 50) also has $1 of intrinsic value and, therefore, $1.50 of time value. Choice A is eliminated. An Oct 50 put has ZERO intrinsic value, so the time value is $2.00. Choice B is eliminated. An Oct 55 put has $4 of intrinsic value, so only 25 cents per share of time value. D is eliminated. The Answer is . . .









c

Painful Options Question

As I was saying in today's Friday Free Broadcast, the Series 7 questions on options will often not involve calculations. For many people, questions similar to the one below are among the most difficult because they force the test taker to really know how options work:

Which of the following option series trades at the highest premium?
A. ABC Apr 30 put
B. ABC Apr 40 put
C. ABC May 45 put
D. ABC Jun 45 put


Okay, it seems there may be information missing. Unfortunately, there isn't. No stock price provided in the question? There's your clue--it can't matter what the stock price is. The test is hard, but it's not a rigged game. If the stock price were required to answer the question, it would be provided. It wasn't provided, so it doesn't matter. Why doesn't it matter? Because puts with higher strike prices are worth more money, period. No matter where the stock is right now, the right to sell it for $45 is worth more than the right to sell it for $40 or $30. So, the answer has to be the May 45 put or the Jun 45 put. Which one gives the buyer more time to win? The Jun 45 put. That's the one that's worth the most.




ANSWER: d

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.

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.

Writing Puts

Writing puts is probably the strangest of the four single options positions. First, it's hard enough for most people to understand what a "put" is and why someone would want to buy a put, which is the "right to sell stock at a set price." But, if you feel that Starbucks is about to drop, you can buy a put to see if you're correct. If so, the put becomes more valuable. Or, if you already own Starbucks common stock and are afraid it could drop, you could buy a put to protect yourself. If you have the "right to sell SBUX @20," it doesn't matter if SBUX drops to 5, or even 0--somebody has to let you sell the stock to him for $20. Who is that somebody?
Somebody who wrote the SBUX 20 put. He sold you the put a while back because he was convinced the stock would stay at $20 or higher (bullish/neutral). Turns out, he was wrong, and now he has to let you sell him the stock @20. He has the "obligation to buy the stock at 20," in other words. Notice how I try to focus on the buyer's perspective--he has the right to sell the stock for $20, so the seller of the put has to honor that contract. Or, we could say that the put writer is "obligated to buy the stock at the strike price."
Okay, so if I am "bullish" on Starbucks (SBUX), I can buy calls on SBUX. If the stock drops, I could lose the entire premium paid for the call options. Or, I could sell/write puts on SBUX, thinking the stock will either rise or stay where it is. Some people prefer to take money in from an option by selling, but if the stock drops, the put writer can get bruised pretty bad. If you sell a SBUX Sep 20 put @2, the stock could drop to 0. And then you'd have to pay $20 to somebody for a worthless stock, with only a $2 premium to show for it. And, the higher the strike price, the bigger the risk to a put writer. I don't want to be "obligated to buy" a worthless stock for $80, $90, $100. Of course, I don't write options, or buy them. We have plenty of riverboat gambling in the greater Chicago area if I feel a need to throw my money away.