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Reading 73: Risk Management Applications of Option Strategies

Session 17: Derivatives
Reading 73: Risk Management Applications of Option Strategies

LOS b: Determine the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph of a covered call strategy and a protective put strategy, and explain the risk management application of each strategy.

 

 

Given the payoff diagram shown below of an option combined with a long position in a stock, which of the following statements most accurately describes the profit or loss potential to the holder of the combined position?

A)
The maximum profit on the long call is unlimited.
B)
The maximum profit on the short put is $2.
C)
The maximum loss on the long put is its cost.


 

This is a graph of a protective put, which is a combination of owning the stock and purchasing a put on the same stock. The maximum loss on the put is its $2 cost. The statements regarding the maximum profit on a long call or a short put are true, but neither of these positions are held by the owner of the protective put.

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


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.

TOP

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


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.

TOP

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

A)
short call.
B)
long call.
C)
covered call.


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

TOP

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.


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.

TOP

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.


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.

TOP

The potential profits from writing a covered call position on a stock are:

A)
limited to the premium.
B)
greater than the potential profits from owning the stock.
C)
limited to the premium plus stock appreciation up to the exercise price.


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.  The owner of a stock has the rights to all upside potential. The profits for a short call are limited to the premium.

For example, say that a stock owner writes a covered call at a stock price (S) of $50 and an exercise price (X) of $55 for a premium of $4. If at expiration, the price of the stock is more than $50 but less than $55, the buyer will not exercise, and the writer will "gain" the premium plus any stock appreciation between $50 and $55. If at expiration, the price of the stock is more than $55, the buyer will exercise and the writer's gain is limited to the premium.

TOP

Given the covered call option diagram below and the following information, what are the dollar values for points X and Y? The market price of the stock is $70, the strike price of the call is $80, and the call premium is $5.

Point X Point Y

A)
$80 $15
B)
$80 $5
C)
$75 $15


The kink in the diagram of a covered call is always at the exercise price of the option. Therefore, point X is $80. As the stock price rises above $80, the stock is called away and the maximum gain is the call premium plus the stock price gain ($80 ? $70). The maximum gain, then, at point Y is ($5 + $10 = $15).

TOP

The profit/loss diagram for a covered call strategy looks like what other type of profit/loss diagram?

A)
Long put.
B)
Short call.
C)
Short put.


The profit/loss diagram for the covered call looks like the profit/loss diagram for a short put position. Both option positions have limited profit potential, with the potential loss equal to the strike price less the premium.

TOP

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.


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).

TOP

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