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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) lost $11.55.

B) gained $11.55.

C) gained $1.45.

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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).

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George Mote owns stock in IBM currently valued at $112 per share. Mote writes a call option on IBM with an exercise price of $120. The call option is sold for $1.80. At expiration, the price of IBM is $115. What is Mote’s profit (or loss) from his covered call strategy? Mote:

A) gained $4.80.

B) gained $3.00.

C) lost $3.20.

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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 increased in value from $112 per share to $115 per share, creating a $3 gain. The $3 gain in the stock price is added to the $1.80 gain from writing the (unexercised) call option. Therefore, the total gain is $4.80 ($3+$1.80).

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James Jackson currently owns stock in PNG, Inc., valued at $145 per share. Thinking that PNG is overbought and will decrease in price soon, Jackson writes a call option on PNG with an exercise price of $148 for a premium of $2.40. At expiration of the option, PNG stock is valued at $152 per share. What is the profit or loss from Jackson’s covered call strategy?

Jackson:

A) gained $9.40.

B) gained $5.40.

C) lost $4.60.

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The option is in-the-money at expiration (MAX (0, S-X) and the PNG stock will be called away from Jackson at $148 per share, limiting Jackson’s gain from owning the stock to $3 ($148-145). However, Jackson also gains the $2.40 from writing the call

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In June, Todd Puckett bought stock in SBC Communications for $30 per share. At that time, Puckett sold an equivalent number of call options on SBC with an exercise price of $35 for $2.75. In September, at expiration, the stock is trading at $26. What is Puckett’s profit per share from his covered call strategy? Puckett:

A) lost $1.25.

B) gained $1.25.

C) gained $4.00.

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Since the option is out-of-the-money at expiration (MAX (0, S ? X)), the options are worthless. Also, the stock decreased in value from $30 per share to $26 per share, creating a $4 loss. The $4 loss is partially offset by the $2.75 premium Puckett received. Therefore, the loss per share from the covered call position is $1.25 = (–$4 + $2.75).

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Jasper Quartermaine is interested in using the options market to create “insurance” against a severe drop in the value of a stock portfolio that he owns. How could he best accomplish this goal and what is this type of strategy called?'

Type of option

Strategy

A) write call options   protective put

B) buy put options   protective put

C) write call options   covered call

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An investor can simulate portfolio insurance by purchasing put options. Losses in the underlying portfolio are offset by gains in the put position. The investor is already long his portfolio and if he buys a long put for his portfolio he is replicating a protective put strategy.

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Collete Minogue holds stock in Bracken Entertainment. Although many of her associates still believe that Bracken will be a high-performing stock, Minogue has lost faith and wants to conduct a covered call transaction. Current market conditions are as follows:

• Stock price (S) at $33 per share.
• Strike price of $39.
• Premium of $5.
• No transaction costs.

In assessing whether she should conduct the covered call strategy, Minogue sketches out the following graph. Although her sketch is correct, she cannot remember all the labels.

Which of the following statements about the graph and the covered call strategy is least accurate?

A) The distance between points C and D is $5.

B) The call writer will have unlimited upside potential.

C) If Minogue goes ahead with the covered call, she will limit her gain to $11.

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The call buyer has unlimited upside potential. If the stock price exceeds $39, the buyer will exercise the option and will realize all gains (once the cost of the premium is recovered).

The other statements are true. Minogue is the call writer (a covered call consists of the stock and a short call). Her gain is limited to $11 (the call premium of $5 plus the gain on the stock as long as the market price is less than the strike price, or $39 ? $33). The distance between points C and D represents the call premium, or $5.