1215

Donner Foliette holds stock in Hamilton Properties, which is currently trading at $25.70 per share. On the advice of this investment advisor, he conducts a covered call transaction at a strike price of $30 and at a premium of $3.50. The advisor drew the following graph to help explain the transaction.

Which of the following statements about this transaction is least accurate?

A) The call buyer paid $3.50 for the right to any gain above $30.

B) If the stock price falls to $23, Foliette will gain $0.80 per share.

C) Foliette believes the stock will appreciate significantly in the near future.

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One reason for an investor to conduct a covered call transaction is that he believes that the stock's upside potential is limited and he wants to collect some option premiums. The call writer thus trades the stock’s upside potential for the premium. An investor is less likely to write a covered call if he believes the stock's upside potential is significant because he would be giving up the expected gains if the stock is called away.

The information about Foliette’s gains is correct. If the stock price decreases to $23.70, Foliette can realize a gain of $0.80 if he sells the stock ($23.0 value ? $25.70 + $3.50 premium).

1215

In October, James Knight owned stock in Valerio, Inc., that was valued at $45 per share. At that time, Knight sold a call option on Valerio with an exercise price of $60 for $1.45. In December, at expiration, the stock is trading at $32. What is Knight’s profit (or loss) from his covered call strategy? Knight:

A) gained $11.55.

B) gained $1.45.

C) lost $11.55.

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Since the option is out-of-the-money at expiration (MAX (0, S-X)), the option is worthless. Also, the stock decreased in value from $45 per share to $32 per share, creating a $13 loss. The $13 loss is partially offset by the $1.45 premium Knight received. Therefore, the total loss from the covered call position is $11.55 (-$13+$1.45).

1215

An investor buys a 30 put on a share of stock for a premium of $7 and simultaneously buys a share of stock for $26. The breakeven price on the position and the maximum gain on the position are:

Breakeven price

Maximum gain

A) $21 $11

B) $37 $11

C) $33 unlimited

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To break even, the stock price should rise as high as the amount invested, $33 ($26 + $7). The maximum gain is unlimited, as the gain will be as high as the increase in the stock price.

1215

An investor buys a share of stock at $33 and simultaneously writes a 35 call for a premium of $3. What is the maximum gain and loss?

Maximum Gain

Maximum Loss

A) $5 $30

B) unlimited -$33

C) $2 -$35

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The maximum gain on the stock itself is $2 ($35 ? $33). At stock prices above the exercise price, the stock will be called away from the investor. The gain from writing the call is $3 so the total maximum gain is $5. If the stock ends up worthless, the call writer still has the call premium of $3 to offset the $33 loss on the stock so the total maximum loss is $30.

1215

The shape of a protective put payoff diagram is most similar to a:

A) short call.

B) long call.

C) covered call.

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The payoff diagram for a protective put is like that of a call option but shifted upward by the exercise price of the put.

1215

A covered call position is:

A) the purchase of a share of stock with a simultaneous sale of a call on that stock.

B) the simultaneous purchase of the call and the underlying asset.

C) the purchase of a share of stock with a simultaneous sale of a put on that stock.

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The covered call: stock plus a short call. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call.

1215

A covered call position is equivalent to:

A) owning the stock and a long call.

B) owning the stock and a long put.

C) a short put.

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The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call.  This is similar reasoning to selling (or going short) a put. A put is in-the-money when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay the premium and never exercise, the seller wants the price of the stock to remain above the exercise price.