Derivatives【Reading 65】Sample

kim226

A call option has a strike price of $35 and the stock price is $47 at expiration. What is the expiration day value of the call option?

A) $0.

B) $12.

C) $35.

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A call option has an expiration day value of MAX (0, S − X). Here, X is $35 and S is $47.

kim226

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) $33 unlimited

B) $21 $11

C) $37 $11

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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.

kim226

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.

kim226

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

A) long call.

B) short 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.

kim226

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.

kim226

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.

kim226

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

A) limited to the premium plus stock appreciation up to the exercise price.

B) limited to the premium.

C) greater than the potential profits from owning the stock.

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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.  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.

kim226

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

A) Short put.

B) Long put.

C) Short call.

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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.

kim226

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) lost $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).

kim226

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 $3.00.

B) gained $4.80.

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).