Difficult options question

The so-called "T-chart" is useful when you have to track money-in and money-out on an actual series of transactions, or a series of potential transactions. The following question requires a T-chart and some good, creative problem-solving:

If an investor purchases 100 ABC @44, then writes 1 ABC Aug 45 call @2 and 1 ABC Aug 45 put @2.50, his maximum loss is
A. $450
B. $100
C. $8,450
D. $4,400

EXPLANATION: if the stock goes up and gets called away at $45, that's actually the best that can happen and would be his maximum gain. The worst that can happen is that the stock drops to zero, a loss of $4,400. Then, he'd have to give some clown $4,500 for a worthless stock when the put is exercised. That's $8,900 out, with only $450 coming in for selling the straddle.



ANSWER: c

Options orders

Many of the options questions on the Series 7 have nothing to do with numbers.
Like this:

If one of your investing clients wrote put options a few weeks ago and would now like to liquidate the position, you would enter which of the following orders on his behalf?
A. opening sale
B. closing sale
C. closing purchase
D. opening purchase

EXPLANATION: a registered rep could really mess things up by checking off the wrong box among the four choices above. For example, if your customer wanted to buy call options, you could really do damage if you checked "opening sale" when you meant "opening purchase." Suddenly, because of your mistake, the guy is subject to huge and even unlimited losses by writing naked calls. A "long" position is initiated with an opening purchase. A short position is initiated with an opening sale. Here, the client has written options, so he's already done an opening sale. He needs to close out by buying them back--closing purchase. Some students will read this explanation and think, "Okay, I have to memorize these four things." To which I would say, "No. You have to understand them." If you understand the concepts surrounding options, you will get 90% or more of those questions right on the exam. Which is a good thing.



ANSWER: c

Today I REALLY Feel Your Pain

We now intend to update each of the five books every year, and I made the decision to start with the Big Kahuna, the Series 7. In order to see what we might be missing that the "big companies" are covering, I have to go through their practice questions and their . . . well, let's call them "books" for lack of a better name.

OMG! WTF?

If you've ever felt overwhelmed and discouraged about studying for your Series 7, I now know why. What a bunch of soulless, joyless, ugly nonsense your firms are forcing you to read. It's as if the writers of the so-called "books" are convinced that their superiority to you is in direct proportion to your confusion. First, they're not superior. You will make more money selling financial services than they do writing mindless drivel about DPPs and variable-rate demand notes. Second, who the heck said that finance and investing are dull topics? Warren Buffett and Charlie Munger hold the Qwest Center overflow audience's attention for 5 or 6 hours . . . why can't these Series 7 "license exam manuals" explain how corporations raise capital without making you want to jam a hot needle in your eye socket every couple of minutes?

Oh well. No use complaining. In fact, I should send the "big guys" a big thank-you note today for guaranteeing that there will always be a market space for us, for readers who want to learn without losing their sanity. Just wanted you to know that if you find your "license exam manual" to be boring and poorly written, it's not just you.

Trust me.

Taxation and Mutual Funds

Let's take a look at a question about mutual fund taxation . . .

All of the following are taxable in relation to a mutual fund investment except
A. undistributed capital gains
B. unrealized capital gains
C. reinvested capital gains distributions
D. capital gains distributions from a tax-exempt municipal bond fund

EXPLANATION: a surprising fact about capital gains that a mutual fund portfolio manager realizes is that even if they're not paid out to shareholders, the shareholders are taxed on their fair share of the gains. If the fund does distribute capital gains, the investor is taxed whether she cashes the check or reinvests automatically. And, municipal bonds are subject to capital gains taxes just like other securities. Of course, if a capital gain is "unrealized," there is no capital gain.



ANSWER: b

Straddle question

Bobby Bobson bought a BCD Mar 55 call @3 and a BCD Mar 55 put @3.50. If BCD becomes worthless, the resulting profit or loss would be
A. loss of $650
B. loss of $5,200
C. gain of $650
D. gain of $4,850

EXPLANATION: the questions on the exam are often not as clear as you'd like. What does it mean "if BCD becomes worthless"? It means the underlying common stock goes to zero, kaput. So, Bobby loses just the total premium of $650, right?
Not right. If the stock becomes worthless, the right to sell it (Mar 55 put) is worth $5,500. $5,500 minus the $650 he paid for the position = a gain of $4,850.

ANSWER: d

Time Value Once Again

On our Facebook fan page, we asked visitors which option would trade for a higher premium here in July: MSFT Aug 30 call or MSFT Oct 30 call. At first, it might seem that you need more information . . . well, what is the underlying stock trading for?

Doesn't matter.

Huh?

No matter what MSFT common stock is trading for, the time value is higher on the Oct 30 call. Why? Because--get this--there is more time on the option. See, the premium is the market's collective opinion on the buyer's chance of winning. Period. The market as a collective is so efficient at assigning a value based on probabilities, in fact, that right after the Sep 11th attacks, the US Government actually floated the idea of creating a "terrorism exchange" on which speculators would bet on where the next attack might occur. Maybe they realized how sick the temptation for market manipulation would have been--go long the Los Angeles Mar 15s and then pay some sickos to blow up LAX--or maybe their sanity suddenly returned. Either way, they did not actually create such an exchange, thankfully, as it would have been, you know, crazy. Still, their premise was correct--a market of speculators is very good at determining a fair price for an option based on its probability of working out for the buyer. If the underlying stock trades at $29, an Aug 30 call is worth more than an Aug 35 call, even though both are out-of-the-money. Why aren't they both worth 0? Because there is a chance the stock can rise above $30 before expiration, and a chance it could rise above $35. Which chance is more likely? Obviously, the Aug 30 call has a more realistic chance of going in-the-money, so its time value is higher than the Aug 35 option. If it's early July, maybe the Aug 30 calls trade for $1.50, with the Aug 35 calls trading at just $.45. It actually depends on how volatile the stock is. If it's the kind of stock that jumps around all the time, the market might charge you $2.00 even for the Aug 35 call. The market is saying the stock could easily rise that high that fast. Google options trade at high premiums, because that stock can easily rise or fall $20 in a week. Microsoft, on the other hand, is so sluggish and predictable that the options are cheap. The market basically says no way is MSFT going up $10 any time soon. You can buy these options dirt cheap.

So, what determines the premium of a call option?

1. the market price of the underlying stock

2. the amount of time left on the option

3. the volatility of the underlying stock

An army of computer-modeling, big-brain speculators plug those factors into their software and, voila, an options premium becomes X, Y, or Z. I know it hurts to think this hard about the concept of an option. But, trust me, your score will go up if you understand options well beyond any little chart or cheat-sheet.

Tombstone

The Series 7 could ask you what information is contained in a "tombstone ad." First, remember the context: we're talking about a new offering of securities. Once the registration statement has been filed with the SEC, the issuer and underwriters go into a cooling off period. During this period, no sales or advertising is allowed. Tombstone ads, however, are okay, since they don't really entice anyone or make any claims. They just provide the bare bones facts about an offer of securities. They simply announce that an offering of common stock, preferred stock, bonds etc. is available from a particular issuer. The number of shares is listed, as is the offering price. Then, we see the underwriters, with the lead underwriters in larger text than the syndicate members taking a smaller percentage of the offering. And, there is the disclaimer that this announcement is not an offer to sell the securities or the solicitation of an offer to buy the securities. It's just an announcement. It might help to look at one, which you can do at this link: http://www.buec.udel.edu/pollacks/Acct351/handouts/AT&T%20tombstone%20ad.jpg.