Answers to Questions and Exercise for Discussion
1. c
2. a
3. b
Discussion: Look for analytical skills of the student. First, did they properly study the key areas of fundamental analysis (dividend yield, dividend increases for 190 years, range of P/E ratio, revenue, net earnings, and long-term debt capitalization). All of these areas should have been studied over a number of years. Second, were students able to make judgments concerning the fundamental strength or weakness of the companies selected?
Chapter 2
1. c
2. a
3. c
Discussion: Study whether students have been able to recognize varying risks based on the moneyness of options. Also look for students’ ability to compare risks and opportunities based on premium levels, as well as on time to expiration. This exercise is essential in order to understand how options function and how varying risk levels define a conservative portfolio.
Chapter 3
1. c
2. a
3. c
Discussion: A primary element of timing for covered calls consists of finding a stock chart with current price above the original purchase price. Second, if price has been trending upward but has appeared to plateau, ATM calls are likely to be priced attractively. Selling calls at this top price will be timed well. Look for analytical skill among students in recognizing when current trends are coming to an end and when timing for short trades are ideal.
Chapter 4
1. b
2. a
3. d
Discussion: Look for insights among students into what counts as significant signals and when strong confirmation is also found. Also encourage students to identify patterns of resistance and support, unusual gapping price activity, and other forms of signals beyond reversal.
Chapter 5
1. d
2. a
3. c
Discussion: Students should be able to demonstrate a working knowledge of options to be used in a recovery strategy. With price decline, strategies may involve buying calls to benefit from rising prices; selling puts to benefit from declining time value; or least of all, buying more shares to average down the price. This last method is least desirable because if the price continues to drop, the net paper losses are made worse. With options, the maximum loss is a relatively small premium paid for a call, or the points lost in stock minus the premium received for a short put.
Chapter 6
1. d
2. d
3. c
Discussion: Students should be able to calculate net basis as price per share minus net premium to be received for selling a call. They should also be able to identify the breakeven point for writing a subsequent covered call or uncovered put, as a recovery strategy based on short options.
Chapter 7
1. c
2. b
3. a
Discussion: The 1-2-3 describes the use of three different expiration cycles and a reverse butterfly in the middle area. Look for ability among students to set up an appropriate situation creating a net credit. Also determine whether students have used the proper bid or ask prices, adjusted for trading fee levels. Finally, identify whether students have been able to set up the strategy while avoiding positions expiring in ex-dividend month.
Chapter 8
1. a
2. b
3. b
Discussion: Students should be able to identify the three possible outcomes and calculate the net cost of the position, paper profits in stock, and outcome in each of the three cases. This ability to analytically study the dividend collar is essential to an understanding of the three-part strategy.
Chapter 9
1. a
2. c
3. c
Discussion: Expect students to understand the concept of contingent purchase risk by articulating three methods for reducing both cost and exposure. These should include using higher strikes (for calls) or lower strikes (for puts), both of which will reduce the price of options. However, this also means that reaching a profitable position requires greater price movement than using ATM contracts. A second method is to focus on longer-term options. The greater time to expiration is an advantage, but students should analyze the time benefit versus the higher cost. Third, and perhaps most effective, long-term long calls or puts can be offset by very short-term positions, designed to expire quickly and be replaced, thus eventually paying for the long options.
Chapter 10
1. c
2. a
3. d
Discussion: Students should be familiar with the discussion in this chapter and should explain the following and make accurate comparisons: margin and collateral requirements, outcome when stock prices rise, outcome when stock prices fall, and dividends.
Chapter 11
1. b
2. a
3. d
Discussion: Look for an understanding not only of the rules, but also how they affect options trading with tax consequences in mind. The wash-sale rule states that a closed position is taxed in the year closed as long as a comparable or identical position is not opened within 30 days. The anti-straddle rule is designed to prevent claiming a net loss this year and profit next year for two-sided transactions. And the unqualified covered call may curtail the ability to claim a favorable long-term capital gain when covered calls are too deep in the money. Students should be able to analyze these rules in the context of planning options strategies to mitigate tax consequences.
Chapter 12
1. b
2. a
3. d
Discussion: The student should be able to explain why the combination of inflation and taxes create the true net breakeven yield investors need. The discussion should include an analysis of how risk and return interact and why it is a mistake to increase risks beyond tolerance levels to meet or exceed breakeven. Look for a clear explanation of the formula
I ÷ (100 − R) = B and what each element of the formula represents.
Chapter 13
1. c
2. a
3. d
Discussion: Expect students to be able to list the four areas: revenue and earnings trends, capitalization and working capital, P/E range over time, and dividend history. Look for a logical analysis of the role each of these fundamental trends plays in defining value of a company and its stock, and also to explain why strong fundamentals translate to safe and strong options positions.