CFA Practice Question

CFA Practice Question

A bullish investor believes that Clay Industries common stock is about to experience a substantial increase in price. He enters into an option position requiring him to purchase 500 shares of Clay Industries common stock for a price of $45, if the option is exercised. The assignment can take place at any time until the expiration of the contract. Which of the following correctly describes the option position entered into by this investor?
A. Long European puts
B. Short American puts
C. Long American calls
Explanation: Remember that long put options give the holder the right to sell an underlying security at a specified price for a specified time period, whereas long calls give the holder the right to purchase the underlying security for a specified price and for a specified time period. "European" options may only be exercised upon the expiration of the contract, whereas "American" options may be exercised at any time during the life of the contract. These terms refer only to the exercise privileges given to option holders, and have nothing to do with geographical proximity (i.e., "European" option contracts do trade in the U.S. and other locations outside of Europe, and "American" options trade both within and outside of the U.S.). Another fundamentally important fact to remember is the fact that long option contracts give the holder the RIGHT or "option" to buy (calls) or sell (puts) the underlying security, whereas short options positions OBLIGATE the writer to purchase (puts) or sell (calls) the underlying security, if the option is exercised. In this example, the investor has entered into an obligation; therefore, we know the option position must be short. Further, since we know that the investor is required to purchase the underlying shares, we know that this is an example of a short put contract.

Effectively, the investor is accepting a premium in exchange for obligating himself to accept the shares being put to him should the contract be assigned. Finally, we can determine that these short put contracts are "American" options because the assignment may take place at any time up to and including the expiration of the contracts.

User Contributed Comments 11

User Comment
creativemny Key word. "Required"
dimos Yes but one can claim that the holder of a long call option ("if the option is exercised") is also "required" to purchase the shares. In addition, a long American option, is suitable in this case since the investor believes that the stock price will increase... Any comments?
danlan A long call is NOT "required" to purchase the shares, it is optional to purchase the shares.
wollogo I see your point dimos, but the most logical interpretation of the questions is that you are obliged to purchase the stock at the discresion of the option holder i.e. a put. Danlan - long call IS required to purchase the shares if they CHOOSE to excercise the option, the choice to excercise is optional.
ofabian agree with dimos...- i was thinking that if you exercised the call option, obviously you would be required to purchase the shares.
boddunah it got me. "requiring" is key.

long call ---> right to buy
short call ----> obligated to sell if exercised.
long put ----> right to sell
short put ----> obligated to buy.
djread "required if exercised" got me...transacting will always be required upon exercise
cjpatel if I am bullish on something i will take the right to buy it coz i dont wanna lose the profit..... I dont see any sense here..
mindi tricky!!!!!!!
Andy552 with a short put, if you dont believe the equity price will fall, you will gain the premium. So it would make sense if you're bullish on stock prices.

A long call you only make money if the increase in stock price is > the premium paid.
thebkr7 Agree with Dimos
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