2012 mock q 44 and q43

q44 The butterfly has a negative cost, it brings in cash, which should not hold in the market

the bull spread with calls we are buying starts paying sooner than the bull spread with calls we are selling, it thus should cost more and we should have to pay a cash at the start

Under the given prices you can buy a bull with calls that starts paying at 1100 and stops at 1125 for a cost of 15.35

You can buy a bull with calls that starts paying at 1125 and stops as 1150 for 15.8

no one would pay more for a bull spread that starts paying at a higher price than one that starts paying at a lower price esp that the max gain of both is the same =25

also the question sais using exhibit 1 and does not specify to use calls, you could purchase a high put, sell 2 puts at a lower price, the purchase a put at an even lower price, and that would be a butterfly spread

q43 the say a covered call does not reduce exposure, page 407 in CFAI said they do.

I agree about #43. It has to be a mistake.

I agree as well with respect to Question #43. Only thing I can think of is that it said “provide protection against losses,” instead of “provide some protection against losses.” This wasn’t on the mock errata, right? So what’s the best way to think about covered calls and downside protection – only that the premium buffers your losses somewhat, but they can trick you with wording, just like here.

Question 44 applying the multiplier to the payoff less the premium seems incorrect. You don’t apply the multiplier to the cost of the options agreed?

Agreed on #44, that was a terrible question by the CFAI. You can do a butterfly spread with either calls or puts and it does not specify which one. Also the max loss on the butterfly call spread would be = a $45 gain. So worst case scenario on this transaction you make $45 and best case you make $2,545…seems like a pretty good deal.

I also paused on #43 because I remembered reading in the text that covered calls offer some downside protection. I think that is a mistake in the text. Nobody in reality is selling covered calls for downside protection, sure your losses would be reduced by the amount of premium income from selling the calls but that is likely to be very small compared to the drop in stock price if their is a big move downward.

Hopefully they can manage to keep inconsistent questions like these off of the acutal exam.

Croker - Yes you do apply the multiplier to the cost of options. Although I think the multiplier should say “100 contracts and not $100”. By saying the multiplier is $100 it is implying that the exercise price is $1,100 X $100 = $110,000 IMO.

I agree covered calls provide some downside protection as you get the premium. It’s not massive , but still some protection. I think there was a question in the book which had this.

look at diagram for covered call, the downside is very large

For 43, I thought of it as the covered call is more an income generator than downside protector. I had A, then changed to B.

it’s really not accurate to say writing covered calls provides downside protection. maybe you say it lowers your implied cost basis, but having been on the floor of the CBOE, traded options for almost 20 years in my PA since i was a teenager, and worked at 3 different hedge funds where options were employed, it’s not appropriate to say it provides “downside protection”. cuz it just doesn’t. it’s an income generator and it lowers your cost basis.

I absolutely agree with you in theory, but technically (and for test purposes), downside protection doesn’t necessarily mean FULL downside protection.

100% correct. If you engage in a covered call you aren’t betting on the market going down (at least very much). You do it largely because you don’t think the market is going anywhere, and the call serves as additional income in the meantime. If the market goes up you can close out the position.

We’ve never used or thought of a covered call strategy as protection.

Book seems to indicate otherwise.

selling a call + holding the underlying - is less risky than selling a naked call. By virtue of willingness to bear some risk - returns are also reduced. So a covered call by that definition has lower downside as well as lower upside.

I got #43 wrong as well…my logic was: if you buy the stock at $10 and it goes up to $50 and you sell a deep-ITM call at a $25 strike, and the price at expiration is $43, then you deliver the stock and receive $25 per share, which equates to a $15 gain plus the call premium (so effectively locking in a minimum value for the stock as long as the call you’re selling expires in the money and is above your desired gain). However, this strategy completely blows up if the stock tanks and the call expires worthless - so in retrospect I no longer think that the covered call offers any actual downside protection.

first of all almost anything is going to be less risky than selling naked calls or puts. that’s just inherent in the contract. if i write naked insurance policies on natural disasters it’s going to be a lot more risky than if i go out and get reinsurance from a major reinsurer like lloyds of london or berkshire to back up what i’m writing.

you can quote whatever crap you want from the book and hope that some academic trash reading from CFAI will approve of your viewpoint. but CFAI even confuses volatility - a pricing component of the option premium with volatility of the stock price itself (movement of underlying). it’s really a joke. put that on top of the fact that CFAI has some hard-on for butterfly trades while completely ignoring strangles and other more common trades, makes it all the more comical. it really is one of the worst written sections in all of the curriculum and any basic options book by james bittman or lawrence macmillan would put it to shame.

covered calls are an income generating tactic and help lower your cost basis. plain and simple. CFAI even have an EOC question with 4 people who have varying market outlooks and various strategies assigned, that verify this viewpoint. market going nowhere and you want to generate some income? write calls.

I’m not as well versed as prophets in options trading (by reading his posts), but I have quite a bit of exposure, both on a personal level and a PM side. He’s dead on. I’ve heard of butterfuly trades, but have never implemented one. Maybe others do, but straddles and strangles are very common. Personally speaking, my “fun money” is usually employed in options trading, either through outright long put/call positions or straddles. Covered calls, collars, protective puts - all commonly used in PM.

diagram says it all boys and girls…ain’t much protection on the down side when you look at that bad boy

They aren’t saying there is much, they are saying there is protection (even if it is minimal). On the test, merely say it has a minimal amount of protection on the downside in the free response section, or look to see if there is a better answer in the multiple choice section. Then move on. There are bigger fish to fry in the last 4 days of study.

Poorly worded question imo. Covered call provides a small amount of downside protection equal to call premium, i.e. the stock could go down by x% and you won’t lose if the premium is x%.