Financial Industry Regulatory Authority (FINRA) Practice Exam

Of the following strategies, which is considered most risky in a strong bull market?

1. Buying calls

2. Writing puts

3. Buying puts

4. Writing calls

The correct answer is: Writing calls

In a strong bull market, writing calls is considered the most risky strategy because it involves selling call options without owning the underlying security (a position known as "naked calls"). When an investor writes call options, they are agreeing to sell the underlying asset at the strike price if the option is exercised by the buyer. In a bull market, the price of the underlying asset is likely to rise significantly, which poses a high risk to the writer of the calls because they may not have the shares to deliver upon exercise. If the price of the underlying asset soars above the strike price of the calls written, the writer will face potentially unlimited losses. This is because they would need to purchase the shares at the market price to fulfill the obligation of the option, which could be dramatically higher than the strike price, thus leading to a considerable financial loss. In contrast, strategies such as buying calls or writing puts can offer limited risk or are structured in a way that benefits from market appreciation. Buying puts, on the other hand, serves as a hedge in a bull market, and therefore does not typically carry the same level of risk as writing calls.