2012 mock q 44 and q43 bull, 1125, butterfly, selling, paying

stalkey

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.

stockjaguar

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

jcole21

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.

ftwcfa

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?

andytrader

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.

johnnyBuz

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.

disiz64

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

defour44

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.

wake2000

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.

justin88

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