Chapter 4 - Options

Question 1

What is an options contract?

Answer 1

A two party contract with a right for a buyer (able to buy the underlying security) and an obligation to the seller (must sell to the buyer of the underlying security).

Question 2

What are the two styles of options? Explain both.

Answer 2

• American and European.
• An American option can be exercised any time before the expiration date. A European option can only be exercised the day before expiration. Most options are American style.

Question 3

When buying options on stock how many shares of the underlying stock will you be purchasing if you exercise your option assuming you buy 1 contract? 10 contracts?

Answer 3

100 shares, 1000 shares

Question 4

What does it mean when you are long a call? long a put? short a call? short a put?

Answer 4

1) long call = right to buy
2) long put = right to sell
3) short call = obligation to sell/fulfill
4) short put = obligation to buy/fulfill

Question 5

Long XYZ Jan 60 call for 3. How much is the premium?

Answer 5

3 or $300 (3*100)

Question 6

Buyers of calls are _______ on the market while their counterparts are_______. Buyers of puts are ________ on the market while their counterparts are _________.

Answer 6

• Bullish
• Bearish
• Bearish
• Bullish

Question 7

For Calls describe when an option is “in the money”, “at the money”, and “out of the money”. If you were long the option when would you exercise your contract?

Answer 7

• ITM - market price > exercise price
• ATM - market price = exercise price
• OTM - market price < exercise price
• The only time you exercise your option is when you are “in the money”

Question 8

What is intrinsic value for a call option? What if the option is “at or out of the money” does it have intrinsic value?

Answer 8

• Intrinsic value = Market price - Strike price

- Options that are at or out the money have an intrinsic value of 0, there can never be a negative intrinsic value.

Question 9

What is the break-even for a call option?

Answer 9

Break-even = Strike price + Premium

Question 10

For Puts describe when an option is “in the money”, “at the money”, and “out of the money”. If you were long the option when would you exercise your contract?

Answer 10

• ITM - market price < exercise price
• ATM - market price = exercise price
• OTM - market price > exercise price
• The only time you exercise your option is when you are “in the money”

Question 11

What is intrinsic value for a put option? What if the option is “at or out of the money” does it have intrinsic value?

Answer 11

• Intrinsic value = Strike price - Market price

- Options that are at or out the money have an intrinsic value of 0, there can never be a negative intrinsic value.

Question 12

What is the break-even for a put option?

Answer 12

Break-even = Strike price - Premium

Question 13

What is the premium on an options contract? What is it composed of?

Answer 13

• The premium is the price paid (or received) for the options contract. The buyer pays the ask/offer price and the seller receives the bid price.
• Premium = Intrinsic Value + Time Value

Question 14

What are the 3 choices a buyer of an options contract has when nearing the expiration date?

Answer 14

• Exercise the option
• Let the option expire
• Sell the contract, or close

Question 15

If an investor is long or short on a stock how can they hedge their position?

Answer 15

If an investor is long on a stock then they may buy a put to hedge against a drop in price for full protection or short a call for partial protection. If an investor is short on a stock they may buy a call to hedge against a rise in price for full protection or short a put for partial protection.

Question 16

What is covered call writing?

Answer 16

Selling calls while having a long stock position. This offers partial protection for the investor and is usually used to generate a better return when stock is trading flat.

Question 17

An investor buys 100 shares of RST at 53 and buys an RST 50 put for 2. What is the maximum loss, gain, and break even for the investor?

Answer 17

• Maximum loss = 3 + 2 = $500
• Maximum gain = unlimited
• Break-even = 53 + 2 = $55

Question 18

An investor buys 100 shares of RST at 53 and writes a RST 55 call at 2. What is the maximum loss, gain and break-even for the investor?

Answer 18

• Maximum loss = Stock falls to 0, 2 - 53 = $5100
• Maximum gain = 2 + 2 = $400
• Break-even = 53 - 2 = $51

Question 19

An investor sells short 100 shares of RST at 58 and buys a RST 60 call at 3. What is the maximum loss, gain and break-even for the investor?

Answer 19

• Maximum loss = 3 + 2 = $500
• Maximum gain = 58 - 3 = $5500
• Break-even = 58 - 3 = $55

Question 20

An investor sells short 100 shares of RST at 55 and writes a RST 55 put at 2.50. What is the maximum loss, gain and break-even for the investor?

Answer 20

• Maximum loss = Unlimited
• Maximum gain = 2.50, $250
• Break-even = 55 + 2.50 = $57.50

Question 21

What is a collar?

Answer 21

An investor can hedge downside risk on a long position on a stock with no out of pocket cash.

Question 22

An investor is long 100 shares of RST at 50, they buy a RST 45 put at 3 and sell a RST 55 call at 3. What is the net cost, maximum loss and gain?

Answer 22

• Net cost = 3 - 3 = $0
• Maximum loss = 45 - 50 = $500
• Maximum gain = 55 - 50 = $500

Question 23

What is a spread?

Answer 23

The simultaneous purchase and sale of an option.

Question 24

What is a call spread? put spread?

Answer 24

Call spread = long call + short call

Put spread = long put + short put

Question 25

What is a price spread or vertical spread? Give an example.

Answer 25

- A spread that has different strike prices but the same expiration month. These are the most common spreads. - Long RST Nov 50 call at 7 and Short RST Nov 60 call at 3

Question 26

What is a time spread or calendar spread? Give an example.

Answer 26

- A spread that has different expirations but the same strike price. - Long RST Nov 60 call at 3 and Short RST Jan 60 call at 5

Question 27

What is a diagonal spread? Give an example.

Answer 27

- A diagonal spread has different expirations and different strike prices. - Long RST Jan 55 call at 6 and Short RST Aug 60 call at 5

Question 28

What is a debit spread? credit spread?

Answer 28

The net cost once an investor has simultaneously bought and sold an option. On the t-chart if the purchase of the option outweighs the proceeds from the sale then it is debit. If the proceeds of the sale outweigh the purchase then it is a credit.

Question 29

Why would an investor use a debit call spread strategy?

Answer 29

A debit call spread is used to reduce cost on a long position since the investor is bullish. The investor also gains partial insurance if the stock falls which once again offsets cost.

Question 30

An investor buys 1 RST November 55 call for 6 and sells 1 RST November 60 call for 3. What is the investors maximum gain, loss, and break-even.

Answer 30

Determine if it is a debit/credit spread. -6 + 3 = -3, Debit Spread. - Maximum gain = 5 - 3 = 2, or $200 - Maximum loss = Debit Spread = -$300 - Break-even = 55 60, 55 + 3 = 58

Question 31

For bullish spread investors what do they want to see happen with the spreads?

Answer 31

Widen, exercise becomes more likely

Question 32

For bearish spread investors what do they want to see happen with spreads?

Answer 32

Narrow, exercise is less likely

Question 33

To calculate the break-even for call spreads and put spreads what do you need to know and how do you calculate them?

Answer 33

- The net premium and the strike prices - Call spreads break-even = Lower Strike + Net Premium - Put spread break-even = Higher Strike - Net Premium

Question 34

For quick reference, how do you calculate max gain and loss on spreads?

Answer 34

- Determine if it is a net debit/credit, if it's a net debit then its max loss. For max gain subtract net debit from the difference in strike prices. - Max gain + Max loss = Difference in Strikes

Question 35

Why would an investor use a credit call spread?

Answer 35

It reduces the risk of the short option and they are bearish.

Question 36

Why would an investor use a debit put spread?

Answer 36

It reduces the cost of the long put position and they are bearish.

Question 37

Buy 1 RST November 55 put at 6 and sell 1 RST November 50 put at 3. What is the maximum gain, loss, and break-even?

Answer 37

- Maximum gain = 2, $200 - Maximum loss = -3, -$300 - Break-even = 50 55, 55 - 3 = 52

Question 38

Why would an investor us a credit put spread?

Answer 38

It reduces the risk of the put position and they are bullish.

Question 39

What is a straddle?

Answer 39

A call and put with the same strike and expiration month.

Question 40

An investor buys 1 ABC Jan 50 call at 3 and buys 1 ABC Jan 50 put at 4. What kind of straddle is this? What is the maximum gain, loss, and break-even?

Answer 40

- Long straddle, investor expects substantial of volatility - Maximum gain = Unlimited - Maximum loss = 3 + 4 = 7, $700 - Break-even = 50 + 7 = 57 and 50 - 7 = 43

Question 41

An investor sells 1 ABC Jan 45 call at 4 and sells 1 ABC Jan 45 put at 5. What kind of straddle is this? What is the maximum gain, loss and break-even?

Answer 41

- Short Straddle, investor doesn't expect much movement - Maximum gain = 4 + 5 = 9 - Maximum loss = Unlimited - Break-even = 45 + 9 = 54 and 45 - 9 = 36

Question 42

True or False: Calls with lower strike prices have higher premiums and puts with higher strike prices are more valuable?

Answer 42

True, both options have better chances of being in the money before expiration of the contract.

Question 43

True or False: If you buy the lower strike price you are bullish?

Answer 43

- True - Buy 1 Jan 50 call and sell 1 Jan 60 call, bull spread - Buy 1 Jan 50 put and sell 1 Jan 60 put, bull spread - Opposite for bears

Question 44

What is a combination? Give an example of a long combination.

Answer 44

A call and a put with different strikes, months, or both. Similar to a straddle strategy. Buy XYZ Jan 40 call and Buy XYZ Jan 45 put.

Question 45

Why would someone use an Index option?

Answer 45

To hedge against portfolio risk. An insurance on the portfolio and helps with systematic risk.

Question 46

An investor buys an index option, 1 OEX Jan 460 call at 3.20. The index is currently at 461. What is the premium, breakeven, intrinsic value, and time value of the option?

Answer 46

Premium = 3.20 * 100 = $320 Breakeven = 460 + 3.20 = 463.20 Intrinsic = 461 - 460 = 1, $100 Time Value = $320 - $100 = $220

Question 47

A customer has a $920,000 portfolio, to hedge, he wants to buy OEX puts that are currently trading at 460. How many contracts will he need to buy in order to hedge his portfolio?

Answer 47

Each contract = 460 * 100 = $46,000 | $920,000/$46,000 = 20 contracts

Question 48

If a stock has a beta of 1.2 what does that mean?

Answer 48

The stock is 20% more volatile than the current market.

Question 49

For an interest rate option, a strike of 35 is what in yield? If rates increase to 45, how much is the increase in dollars? How much is each point worth? Are these options American or European?

Answer 49

Yield = 3.5% 10pt increase = $1000 1pt = $100

Question 50

For currency options what are the sizes? What about Yen? What are strikes quoted in, and for Yen?

Answer 50

Standard currencies are in size of 10k, while Yen is 100k. Strikes are quoted in US cents and Yen is 1/100 of a cent.

Question 51

An investor holds 1 Swiss contract at 1.5. What was the cost of the option?

Answer 51

10,000 * 0.015 = $150 | 1pt = $100

Question 52

Importers would buy what type of option on a foreign currency, and exporters would buy what type of option on a foreign currency?

Answer 52

Importers buy calls and exporters buy puts

Question 53

If an investor has an option that is in the money at expiration and he does nothing what will happen?

Answer 53

The OCC will automatically exercise the option if it is in the money by at least 5 cents.

Question 54

Does a customer have to do anything special to trade options?

Answer 54

Yes they must be provided disclosures and get approval by the branch manager and sign an options agreement

Question 55

What happens to an option when a stock splits? If an investor has 1 ALF 60 call and there is a 2:1 split what happens? A 3:2 split?

Answer 55

Options will split along with the stock. 1 ALF 60 call (2:1) 2 ALF 30 calls 1 ALF 60 call (3:2) 1 ALF 60 call with 150 shares

Question 56

There are 3 tax consequences involved with options, what are they? Explain them.

Answer 56

1) Expiration, buyer loses premium and seller profits, capital loss for buyer and cap gain for seller 2) Closing, capital gain or loss equal to price difference 3) Exercise, no cap gain or loss until exercised. If option is exercised then strike + prem. = cost basis for a call.