Series 7 Exam Question 216: Answer and Explanation

Question: 216

Under which of the following circumstances would an investor face an unlimited maximum loss potential?

I. Short 2 DIM Nov 40 puts

II. Short 400 shares of DIM common stock

III. Short 6 DIM Nov 50 uncovered calls

IV. Short 3 DIM Nov 50 covered calls

• A. I and II
• B. I and III
• C. II and III
• D. II and IV

Correct Answer: C

Explanation:

C. You have to remember that sellers (shorters or writers) of options always face more risk than buyers; the buyer's risk is limited to the amount invested. However, sellers of put options do not face a maximum loss potential that's unlimited because put options go in-the-money when the price of the stock goes down below the strike price, and it can only go down to 0. Sellers of uncovered calls face a maximum loss potential that is unlimited because call options go in-the-money when the price of the stock goes above the strike price, and the seller has to purchase the stock at a price that could go higher and higher. Additionally, investors who short stock as in Statement II face a maximum loss potential that's unlimited because the investors have taken a bearish position and lose money when the price of the security increases, and there's nothing stopping the stock from increasing in value. Investors who have sold covered calls don't face an unlimited maximum loss potential because they have the stock to deliver if exercised.