Practice Exam Question G763M

I think this is the place to ask this but I had this question and got it wrong and was hoping I could get a deeper explanation. Here is the question:
On the same day in a margin account, an investor goes long 1 AXP Jan $95 call and short 1 AXP Dec $95 call when the market price is $105. Which of the following best represents the sentiment of this strategy?
Correct Answer = Premium spread to widen / options to exercise
I thought it was = Premium spread to narrow / options to expire
My thinking was the Dec option was older (I always thought if it didn’t list Premiums, you always pick the furthest month, I.E. Jan has least time value going all the way to Dec which has the most time value. I didn’t think you picked the furthest month from “today’s” actual date do you?)
Any guidance or clarity on my thinking? Thanks!

1 Like

Hi @Teemoto3! Thanks for reaching out here. This is the place to post questions.

Let’s re-establish the spread you encountered:

Long 1 AXP Jan $95 call
Short 1 AXP Dec $95 call

This is a calendar call spread, which we can tell by identifying the spread has different expirations, but the same strike price. Premiums are not offered, so we must use the expiration dates to determine the dominant leg of the spread.

You’re right - the longer (furthest) option will be the dominant side. All we need to do is tweak how you’re looking at it. You don’t want to compare the expiration months to today’s actual date. Given the fact options have 9 months or less to expiration (unless it’s a LEAP option), this must be the December prior to the following January (one month apart). If it was the December following January, it would be 11 months later, which is 2 months beyond the length of a normal option.

With that being said, the long AXP Jan $95 call has more time value, and therefore is identified as the dominant leg of the option. We’ll associate all of the following with this dominant leg:

  • Widen
  • Exercise
  • Debit call spread
  • Long call spread
  • Bull call spread

This is definitely a tough topic, but hopefully this explanation helps solidify your knowledge. If you have any other questions, please let me know!

1 Like

Hi Brandon! Thanks for your reply, this makes sense now, i was NOT looking at it “as December prior to the following January” - so what would it be if it was Feb and Dec? I just want to make sure I am for sure following. I for sure get the rest of the explanation but I just want to make sure I can identify the dominant legs for calendar spreads with no premiums. Thanks again!

1 Like

Great question - good news, you won’t see any test questions (on the actual exam) where you can’t distinguish the longer month. Here’s a good rule of thumb - the expiration months will always be closer, not further. So, if you happened to come across a Feb and Dec spread, the Feb option would be the longer expiration.

1 Like