Tuesday, August 24, 2010

Tough Options Question

Some of the options questions on the Series 65/66 exam can be quite alarming. Like this one:

An investor owns a portfolio of large-cap, blue chip stocks, all of them in the Dow Jones Industrial Average. He fears a downturn and wants to protect his holdings without selling off the stocks. To best protect the portfolio, he should
A. purchase a narrow-based index put
B. purchase a broad-based index put
C. sell a narrow-based index call
D. sell a broad-based index call

EXPLANATION: they key is to know that "the Dow" is a broad-based index of stocks from many different industries. That eliminates the "narrow-based index" choices. Narrow-based indexes focus on a particular sector, i.e. the pharmaceutical or telecommunications index. Now, if the question says the investor wants to generate some income, recommend that he sell an option. When the question says or implies that he just wants to protect a position, have him buy something. He's afraid the index could drop, so he buys a put on the index.


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