Chapter 9: Options: Basic Strategies:

Question 1

The Four Basic Options Transactions:
Single Option Strategies:
Example:

Which of the following option contracts has no time value?

A. ABC OCT 50 call @ 2 with ABC at 51
B. DEF NOV 60 call @ 2 with DEF at 62
C. GHI DEC 50 put @2 with GHI at 49
D. JKL JAN 60 put @ 2 with JKL at 62

Answer 1

Answer: B

An option’s time value is the difference between the premium and the intrinsic value. In choice B, the call option has 2 points of intrinsic value. It is in the money because the strike price is below the market. Therefore, the premium of 2 is equal to the intrinsic value. That means the option is selling at parity and had no time value. In choice A, the option is 1 point in the money. With a premium of 2, the other point represents time value. In choice C, the option is 1 point in the money. With a premium of 2, the other point represents time value. In choice D, the option is 2 points out of the money, so the entire premium is time value.

Question 2

The Four Basic Options Transactions:
Single Option Strategies:

There are four basic strategies available to options investors:

• _____________
• _____________
• _____________
• _____________

Answer 2

• Buying calls
• Selling or writing calls
• Buying puts
• Selling or writing puts

Question 3

The Four Basic Options Transactions:
Single Option Strategies:

How do you buy an Option?
A.
B.

A. Buy a Call
B. Buy a Put

Question 4

The Four Basic Options Transactions:
Single Option Strategies:

The investor is Buying a Call:

Long 1 XYZ Jan 60 call at 3.

We need to be sure we know exactly what that means.

• Long:
The investor has bought the call and has the _________ to exercise the contract.

• XYZ:
The contract includes 100 shares of XYZ stock.

• Jan:
The contract expires on the third Friday of January at 11:59 pm ET.

• 60 :
The exercise (strike) price of the contract is 60.

• Call:
The type of option is a call, and the investor has the right to buy the stock at _________ because she is long the call.

3: The premium of the contract is $3 per share. Contracts are issued with 100 shares, so the total premium is $300. The investor paid the premium to buy the call.

Buyers of calls want the market price of the underlying stock to rise. The investor who owns this call hopes that the market price will rise UP above 60. The investor then has the right to buy the stock at the strike price of 60, even if the market price is _______.

Answer 4

right

60

higher (e.g., 80)

We know that is the strategy because when it comes to buying a call, Call UP is the phrase we remember.

Question 5

The Four Basic Options Transactions:
Single Option Strategies:

The investor is Selling a Call:

Short XYZ Jan 60 call at 3

• Short:
The investor has sold the call and has the _________ to perform if the contract is exercised.

• XYZ:
The contract includes 100 shares of XYZ stock.

• Jan:
The contract expires on the third Friday of January at 11:59 pm ET. If expiration occurs, the writer keeps the premium without any obligation.
60 The strike price of the contract is 60.

• Call:
The type of option is a call, and the investor is obligated to _________ the stock at 60, if exercised, because the investor is short the call.

• 3:
The premium of the contract is $3 per share. Options contracts are issued with 100 shares, so the total premium is $300.

Sellers or writers of calls want the market price of the underlying stock to _________ or _________. The investor who owns this call hopes that the market price will rise above 60. The contract will not be exercised if the market price is at or below 60 at expiration, and the writer keeps the premium of $300 with _________.

Answer 5

obligation

sell

fall or stay the same

no obligation

Question 6

The Four Basic Options Transactions:
Single Option Strategies:
Call Option Holder:
A call buyer is a _________ investor because he wants the market to rise. That way the option gets in the money; it has value. The call may be exercised or sold, and the buyer may make a profit. There is a subtle difference between selling and writing. A writer is looking to open a _________.

Answer 6

bullish

new position

Question 7

The Four Basic Options Transactions:
Single Option Strategies:
Call Option Seller:
A call seller or writer is a _________ investor because the investor wants the market to fall. Alternatively, the seller will be happy if the stock’s price does not rise above the strike price. Because if, at expiration, there is no intrinsic value, the option expires and the seller has earned the premium. There is a subtle difference between selling and writing. A seller is looking to close, that is sell an option he _________ already owns.

Answer 7

bearish or neutral

Question 8

The Four Basic Options Transactions:
Single Option Strategies:

It is critical that you recognize that only ______one side wins. The amount that a buyer makes when the stock price goes up is the amount the seller _______. If the stock price falls or stays at the strike price, the amount the buyer loses is the amount the seller _______.

Answer 8

loses

profits

Question 9

The Four Basic Options Transactions:
Long Call Option Strategies:
Call buyers are bullish on the underlying stock. By purchasing calls, an investor can profit from an increase in a stock’s price while investing a relatively small amount of money. There are many reasons why investors purchase calls:
A. ____________
B. ____________
C. ____________
D. ____________
E. ____________

Answer 9

A. Speculation
B. Deferring a Decision
C. Diversifying Holdings
D. Protection of a Short Stock Position
E. Short Call Option Strategies

Question 10

The Four Basic Options Transactions:
Long Call Option Strategies: ____________:
This is the most common reason for buying calls. Investors can guesstimate on the upward price movement of the stock at only the cost of only paying the premium. Buying the actual stock would require a far greater investment. This is a form of leverage.

Answer 10

Speculation

Question 11

The Four Basic Options Transactions:
Long Call Option Strategies: Speculation:
Leverage Example:
If ABC is trading at $40 this is a cost of $4,000 total and an ABC 40 call is trading at $4 this is a cost of $400 per contract total, the investor can buy either the call option or the stock. If he buys the ABC stock and its price goes up to $50 a share, he makes a $________ profit—a %_____ return on the original $4,000 investment.

This EXACT same movement in the stock will make the ABC 40 call worth at least its intrinsic value of 10 ($1,000). If the investor instead buys the ABC 40 call for $400, he can realize a $________ profit ($1,000 less the $400 premium)—a %_____ return on a $400 investment.

The option strategy provides the investor with greater ________.

However, if the stock price falls, the stock investor risks the entire $4,000 purchase price. (The stock can fall to zero and become worthless.) The call option investor can lose the entire investment, but a $400 loss is ________ painful than a $4,000 loss.

Answer 11

$1,000

25%

$600

150%

leverage (a higher potential percentage return)

less

Question 12

The Four Basic Options Transactions:
Long Call Option Strategies:
_____________:
An investor can buy a call on a stock to lock in a purchase price until the option expires. This allows him to postpone making a financial commitment other than the premium until the expiration date of the option. This is often used when an investor has anticipated funds coming due in the future and wants to preserve today’s price. An example would be a _______ with a penalty for early withdrawal.

Answer 12

Deferring a Decision

maturing CD

Question 13

The Four Basic Options Transactions:
Long Call Option Strategies: _____________:
With limited funds, an investor can buy calls on a variety of stocks and possibly profit from any rise in the options premium.

Answer 13

Diversifying Holdings

Question 14

The Four Basic Options Transactions:
Long Call Option Strategies: _____________:
Investors can use calls to protect a specific stock positions. The option acts as an ________ against the stock rising in price. Investors who short stock lose when the price of the stock rises. Because there is theoretically no limit as to how high that price can go, these investors face a potentially unlimited loss. A popular way to hedge (protect) against that loss is to buy a ________ on the stock position. That way, short sellers know the _______ they would have to pay to cover their short stock position.

Answer 14

Protection of a Short Stock Position:

insurance policy

call option

most

Question 15

The Four Basic Options Transactions:
Long Call Option Strategies:

Call ________ are bearish or neutral on the price of the underlying stock. An investor who believes a stock’s price will decline or stay the same can write calls for any of the following reasons:
• ____________
• ____________
• ____________
• ____________

Answer 15

writers

• Increasing Returns
• Speculation
• Locking in a Sale Price
• Protection of a Long Position

Question 16

The Four Basic Options Transactions:
Short Call Option Strategies:
Call writers are _________ on the price of the underlying stock. An investor who believes a stock’s price will decline or stay the same can write calls for any of the following reasons:
A. _________
B. _________
C. _________
D. _________
E. _________

Answer 16

bearish or neutral

A. Increasing Returns
B. Speculation
C. Locking in a Sale Price
D. Protection of a Long Position
E. Ratio Call Writing

Question 18

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered vs. Uncovered Call Writers:
Before we go further, it is necessary to distinguish between a covered and an uncovered call option. First of all, these terms are related only to _________ calls. There is no such term as a covered (or uncovered) ______ call. These do not EXIST.

Answer 18

short

long

Question 19

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered vs. Uncovered Call Writers:
When a call option is covered, it means the investor _________ the number of shares covered by the option contract.

Answer 19

owns

Question 20

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered Call Writers:
Example: if the writer is selling three contracts, 300 shares of the stock is in the writer’s account. Instead of having the actual stock, the option can be covered by a security convertible, at no cost, into the appropriate number of shares. That would include _________ or _________.

Answer 20

convertible debentures

preferred stock

Question 21

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered Call Writers:
A second way to cover a short call is with a long call with the _________ or _________ strike price and an expiration date no _________ than that of the short call.

Answer 21

same or lower

sooner

Question 22

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered Call Writers:
Example: If an investor who does not own the stock sells an LMN OCT 45 call and buys an LMN OCT 40 call, she has covered the short call. If the price of the LMN stock goes up, say to 60, the 45 call will be exercised. The investor does not have the stock. However, instead of having to go into the marketplace and buy LMN at _______, she will exercise her long 40 call, and the stock purchased at _______ will be used to deliver against the exercise of the 45 call.

Answer 22

60

40

Question 23

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered vs. Uncovered Call Writers:
A call option is uncovered when an investor sells a call option _______ owning the underlying stock or other related assets that would enable the investor to deliver the stock should the option be exercised. You may also see this referred to as a _______.

Answer 23

without

naked short

Question 24

The Four Basic Options Transactions:
Short Call Option Strategies:
Covered vs. Uncovered Call Writers: Remember, the seller of an option has an _______. The OCC, which stands behind all options exercised, wants to be sure that if exercised, the seller can perform. In the case of a call, the obligation is to deliver stock. If the writer already has the stock (or something convertible into it), we know the obligation can be met. When the option is uncovered, that _______ does not exist.

Answer 24

obligation

protection

Question 25

The Four Basic Options Transactions: Short Call Option Strategies: Covered vs. Uncovered Call Writers: A corporation cannot write calls on common stock it has issued on _______.

Answer 25

itself

Question 26

The Four Basic Options Transactions: Short Call Option Strategies: Covered vs. Uncovered Call Writers: Naked call sellers face _______ potential risk of loss. Remember, the obligation of a call writer is to deliver stock at the exercise price. A call option will be exercised when the market price is above the strike price. When that happens to an uncovered writer, the investor must buy the stock in the market, paying whatever the _______ price is. As we have discussed previously, there is no theoretical limit as to how high a stock's price can go.

Answer 26

unlimited current

Question 27

The Four Basic Options Transactions: Short Call Option Strategies: Covered vs. Uncovered Call Writers: You will need to know for the exam the two strategies in the investment business that have the potential for an unlimited loss: • _________ • _________

Answer 27

• Selling an uncovered call option • Selling stock short

Question 28

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: Writing covered options is an _________ strategy. If the option is covered, the premium adds to any _________ on the underlying stock. This generates additional income for the portfolio. Investors hope for _________ of the calls so they can keep the premiums.

Answer 28

Increasing Returns income gains expiration

Question 29

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: By selling calls, an investor can profit if the stock's price falls _________ or _________ the strike price. The investor will then earn the entire premium. This is most often the strategy of the _________ seller.

Answer 29

Speculation below or stays at uncovered

Question 30

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: If an investor has an unrealized profit in a stock and is interested in selling it, a call can be written at _________ that will attempt to lock in that profit by matching it.

Answer 30

Locking in a Sale Price The same exercise price (as the long profit gained price)

Question 31

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: Example: An investor owns 100 shares of RFQ purchased at $50 per share. The stock is now selling at $75 per share. He is sitting with an unrealized profit of $_________ per share but is concerned the market may turn the other way. If the investor writes an RFQ _________ call for 4 points and the stock goes up to $85 per share, the option is _________ points in the money. That means the holder (owner) of the call will certainly exercise and the writer will wind up selling his stock at the $75 exercise price. Yes, it would have been nice to still own the stock, but the investor did make a total profit of $_________.

Answer 31

Locking in a Sale Price $25 75 10 $29 ($25 per share profit + $4 premium) ($25 + $4 = $29) A premium of 4 points would keep the investor from losing money until the stock dropped below $_________ $71 ($75 – $4 = $71).

Question 32

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: The premium collected from writing a call provides _________ downside protection to the extent of the _________. A premium of 4 points would keep the investor from losing money until the stock dropped below $_________.

Answer 32

Protection of a Long Position: limited premium received $71 ($75 – $4 = $71)

Question 33

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: Ratio Call Writing: Ratio call writing involves selling more calls than the long stock position _________. This strategy generates additional premium income for the investor but also entails _________ risk because of the short uncovered calls.

Answer 33

covers unlimited

Question 34

The Four Basic Options Transactions: Short Call Option Strategies: Covered Call Writers: An investor who believes a stock's price will decline or stay the same can write calls for any of the following reasons: _________: Example: An investor who is long 100 shares of HIJ common stock sells or writes _________ HIJ OCT 45 calls. This is a ratio write because the ratio of total calls to covered calls is _________. The 100 shares in the account are enough to cover one of the calls. The other call is uncovered, and that means the potential loss is _________.

Answer 34

Ratio Call Writing 2 (200 Shares) 100 (Shares Owned) 2:1 unlimited

Question 35

The Four Basic Options Transactions: Long Put Option Strategies: Put buyers are _________ bearish on the underlying stock. By purchasing puts, an investor can profit from a _________ in a stock's price while investing a relatively small amount of money.

Answer 35

decrease

Question 36

The Four Basic Options Transactions: Long Put Option Strategies: The following are reasons that investors purchase puts: _________: Investors can guesstimate on the _________ price movement of the stock by paying only the premium. If the market price of the stock falls _________ the strike price, the option is in the money and may result in a profit to the buyer. This is a ______-risk alternative to selling a stock short.

Answer 36

Speculation downward below low-risk

Question 37

The Four Basic Options Transactions: Long Put Option Strategies: The following are reasons that investors purchase puts: _________: Investors can buy a put on a stock and lock in a sale price until the option expires. This allows an investor to postpone a _________ until the expiration date of the option. With this strategy, an investor not only locks in an _________ sales price for stock that is owned but also protects its appreciation potential until the expiration date.

Answer 37

Deferring a Decision selling decision acceptable

Question 38

The Four Basic Options Transactions: Long Put Option Strategies: The following are reasons that investors purchase puts: _________: Investors can use puts to protect a long stock position. The option acts as an _________ insurance policy against the stock declining in price. This is the perfect hedge for a _________ position. For the cost of the premium (like any insurance policy), the owner of the stock knows he can sell the position at the _________ strike price, no matter how far the market price falls on the stock he owns.

Answer 38

Protection of a Long Stock Position long stock strike price

Question 39

The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: Covered vs. Uncovered Put Writers Covered puts work like covered calls, except that the covering equity position is a _______ position instead of _______. There are two ways to cover a put: A. __________ B. __________ The obligation of the put writer is to __________ the exercising holder the exercise price. That requires money. A deposit of __________ into the writer's account ensures that the money is there if needed. The concept of the short sale covering the put is a bit more complicated. Just accept the fact that it works.

Answer 39

short stock (unowned shares) long stock (owned shares) A. Taking a short position in the stock underlying the short put B. A cash-covered put pay cash (premium)

Question 40

The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: Put Writers: Put writers are _________ or _________ on the price of the underlying stock. An investor who believes a stock's price will _________ or _________ can write puts for the following reasons: A. _________ B. _________ C. _________ D. _________ E. _________

Answer 40

bullish or neutral increase or stay the same A. Speculation B. Increasing Returns C. Buying Stock Below Its Current Price D. Open Interest E. Put-Call Ratio

Question 41

The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: By selling puts, an investor can profit if the stock's price _________ or _________ the strike price. The investor can profit by keeping the premium.

Answer 41

Speculation rises above or stays at

Question 42

The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: ___________ can be earned for a portfolio by writing puts. Investors hope for expiration of the puts so that they can keep the ___________.

Answer 42

Increasing Returns Income premium

Question 43

The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: The premium received from writing puts can be used to ___________ the cost of stock when the put is exercised against the writer. The writer's actual cost becomes the ___________ strike minus the premium received. This is a popular technique for ___________ institutional investors who believe a stock's current price is too high. The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: Open Interest: One of the tools used to determine strategy is the put-call ratio. It uses the open interest in puts and calls. The open interest in an option is the number of contracts outstanding. The higher the open interest, the more liquid the option. As an option approaches expiration, open interest begins to decline as investors can choose to _________ or _________ close out or exercise existing positions. The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: Put-Call Ratio: The put-call ratio reflects the current open interest in the trading of put options to call options. The ratio can be used as a gauge of investor sentiment (bullish or bearish) and can be calculated to measure broad sectors of the market across many _________ or _________ underlying securities or indices. It can also be used to gauge investor sentiment for just one underlying security. The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: Put-Call Ratio: The ratio is calculated by dividing the number of traded put options by the number of traded call options. The higher the ratio is, the more bearish investors have been up to that point in time. For instance, as the ratio increases, it can be interpreted as an indication that investors felt the _________ or _________ market sector or underlying security would move lower and were buying more puts or that investors were purchasing puts to hedge existing long portfolios in anticipation of a downward move. The Four Basic Options Transactions: Short Put Option Strategies: There are several short put option strategies: ___________: Put-Call Ratio: However, it should also be noted that the ratio can be used as a contrarian indicator by traders. For example, the higher the ratio becomes, the more likely that traders may feel it is time to _________ or _________ close or cover short positions in favor of long positions. In other words, the ratio may have become so high that the continued bearish sentiment begins to diminish, indicating that a reversal may be near.

Answer 43

Buying Stock Below Its Current Price offset