Chapter 3.

Basic Option Strategies

Chapter 3
Basic Option Strategies

Multiple Choice

1. Which of the following strategies most closely resembles the outright purchase of stock?
a. Buy a call, write a call with a higher striking price.
b. Buy a call, write a put.
c. Write a call, write a put.
d. Write a call, buy a put.
ANSWER: B

2. The biggest single disadvantage of writing covered calls is

a. added commissions.
b. increased risk.
c. the necessity to post margin.
d. opportunity losses if exercise occurs.
ANSWER: D

3. Which of the following is a bearish strategy?

a. write calls
b. write puts
c. buy calls and write calls with a higher striking price
d. buy puts and write puts with a higher striking price
ANSWER: A

4. Which of the following is most similar to writing a covered call?

a. writing a naked call
b. buying a protective put
c. writing a naked put
d. writing a covered put
ANSWER: C

5. An investor buys 100 shares of stock at $22 and buys a DEC 20 put @ $1. This person’s
maximum loss is ____________.
a. $300
b. $500
c. $1,900
d. $2,000
ANSWER: A

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6. In question 5, the person’s maximum possible gain is __________.

a. $475
b. $2,000
c. $2,275
d. unlimited
ANSWER: D

7. An investor buys 100 shares of stock at $24 and buys a DEC 20 put @ $1. This person’s
maximum loss is __________.
a. $475
b. $500
c. $2,275
d. $2,000
ANSWER: B

8. An investor buys 200 shares of stock at $23 ¾ and buys one DEC 20 put @ $1. This
person’s maximum loss is ____________.
a. $475
b. $100
c. $2,275
d. $2,850
ANSWER: D

9. In question 8, the person’s maximum gain is ___________.

a. $475
b. $2,000
c. $2,275
d. unlimited
ANSWER: D

10. Selling stock short and simultaneously buying a call is similar to

a. writing a naked call.
b. writing a naked put.
c. buying a put.
d. buying two calls.
ANSWER: C

11. In the “insurance policy” analogy with protective puts, which of the following is most similar
to the “deductible” of the insurance policy?
a. the stock price
b. the striking price
c. the time value of the option
d. the stock price minus the striking price
ANSWER: D

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12. Suppose a speculator is short shares of stock. Which of the following would be the best
hedge against the short position?
a. buying a put
b. writing a put
c. buying a call
d. writing a call
ANSWER: C

13. Which of the following statements is false?

a. Writing covered calls is beneficial in falling markets, but can result in opportunity losses
in rising markets.
b. Writing puts can be beneficial in rising markets, but can result in actual economic losses
in falling markets.
c. Buying calls is beneficial in falling markets, but can result in economic losses in rising
markets.
d. Buying puts can be beneficial in rising or falling markets, but always involves an out-of-
pocket cash outlay.
ANSWER: C

14. An increase in which of the following will cause a call option to decline in value?
a. volatility
b. underlying asset price
c. striking price
d. interest rates
ANSWER: C

15. If someone writes a call while owning the underlying asset, the call is ___________.
a. covered
b. long
c. naked
d. cash-secured
ANSWER: A

16. A long position is a(n)

a. long-term investment.
b. owned asset.
c. borrowed asset.
d. a position with a paper gain.
ANSWER: B

17. If a person writes a covered call with a striking price of $45 and receives $3 in premium,
exercise will occur if the stock price is above ___ on expiration day.
a. $42
b. $45
c. $48
d. $50

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ANSWER: B
18. If stock is purchased at $50 and a $55 call is written for a premium of $2, the maximum
possible gain per share is _________.
a. $2
b. $5
c. $7
d. $10
ANSWER: C

19. If a call option with a striking price of $50 is purchased for $3 ½, the maximum loss is
_____.
a. $3 ½
b. $46 ½
c. $50
d. unlimited
ANSWER: A

20. Which of the following strategies has the highest possible loss?
a. buying a call
b. writing a naked call
c. writing a covered call
d. buying a put
ANSWER: B

21. Which of the following terms is least common?

a. long call
b. short call
c. covered call
d. covered put
ANSWER: D

22. Writing a covered call results in a position similar to a

a. fiduciary put.
b. long put.
c. long call.
d. long stock position.
ANSWER: A

23. Fiduciary puts are also called

a. regulatory puts.
b. cash-secured puts.
c. long puts.
d. uncovered puts.
ANSWER: B

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24. If someone writes a put, they usually want the market to

a. go up.
b. go down.
c. stay unchanged.
d. fluctuate.
ANSWER: A

25. If someone writes a naked call, they usually want the market to
a. go up.
b. go down.
c. stay unchanged.
d. fluctuate.
ANSWER: B

26. A person who sought to buy stock at a price below the current price might
a. buy deep-in-the-money calls.
b. buy deep-in-the-money puts.
c. write deep-in-the-money calls.
d. write deep-in-the-money puts.
ANSWER: D

27. The most common motivation for option overwriting is

a. risk management.
b. tax reduction.
c. leverage.
d. income generation.
ANSWER: D

28. A person who sought to sell stock at a price above the current price might
a. buy deep-in-the-money calls.
b. buy deep-in-the-money puts.
c. write deep-in-the-money calls.
d. write deep-in-the-money puts.
ANSWER: C

29. The simultaneous holding of a long stock position and a long put is called a
a. fiduciary put.
b. protective put.
c. collateralized put.
d. cash-secured put.
ANSWER: B

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30. Index options have little ______ risk.

a. unsystematic
b. systematic
c. market
d. total
ANSWER: A

31. Which of the following is true for writing index calls?

a. It always increases portfolio market risk.
b. It need not involve borrowing any money.
c. It is inappropriate for a tax-exempt investor.
d. It lowers portfolio income.
ANSWER: B

32. A stock sells for $44 ½. An investor writes a $50 covered call at a
premium of $1 1/8. The maximum loss is __________.
a. $ 1 1/8
b. $43 3/8
c. $44 1/2
d. $50
ANSWER: B

33. Six months ago, an investor bought 100 shares of XYZ at $38. Today, the stock sells for $47.
The investor now writes a $50 covered call at a premium of $1 1/8. The most this person can
lose of their original investment is __________.
a. $ 0
b. $11/8
c. $36 7/8
d. $47
ANSWER: C

34. In Problem 33, suppose the investor received a total of $2.00 in cash dividends while owning
the stock. At option expiration, the stock price is $53 and the stock is called. The person's
holding period gain is ____________.
a. 5.26%
b. 34.54%
c 39.80%
d. 47.70%
ANSWER: C

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35. Which of the following statements is most correct regarding the writing of covered calls?
a. The higher the striking price, the higher the premium and the higher the risk.
b. The higher the striking price, the higher the premium and the lower the risk.
c. The higher the striking price, the lower the premium and the higher the risk.
d. The higher the striking price, the lower the premium and the lower the risk.
ANSWER: D

36. Put overwriting is most profitable in

a. rising markets.
b. falling markets.
c. flat markets.
d. periods of high interest rates.
ANSWER: A

Short answer/problem

1. Put overwriting is the practice of writing put options against stock you own rather than
the more common practice of writing covered calls. Explain the things that someone should
be aware of before doing this, including the best and worst things that could happen.

ANSWER: The danger of put overwriting is a drastic fall in the value of the underlying asset.
The best outcome is when the stock advances sharply.

2. Comment on the following statement: “It does not make sense to buy 200 shares of stock,
write one covered call, and buy one protective put. This is equivalent to just owning 100
shares of stock.”

ANSWER: The combination of a covered call, a long put, and an extra long position of 100
shares of stock is approximately equal to holding a single lot of 100 shares of stock. The striking
prices chosen for the options, however, can significantly change the characteristics of the
position. The overall position certainly could make sense in some circumstances.

3. One of the primary motivations for writing stock options is to generate income. Suppose you
own a portfolio of stock and are generally bullish about the stock market for the next six
months. What are the things to consider as you decide whether to write calls or to write
puts?

ANSWER: Writing calls carries with it the chance of losing the stock; writing puts carries the
risk of large losses if the stock price declines sharply.

4. Suppose you have to explain to your boss why writing covered calls and writing puts are
generally equivalent strategies. Select an example from the Wall Street Journal and prepare
two profit/loss diagrams, properly labeled, showing the similarities in these two strategies.

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Also explain in no more than two sentences why your firm, a non-profit corporation, does
not need to be concerned about the fact that puts must be written in a margin account.

ANSWER: Non-profit firms can run into tax trouble if they borrow money in association with
their investment activities. The use of a margin account does not necessarily involve borrowed
funds, however.

5. A $5 million stock portfolio has a beta of 1.10 at a time when the OEX index stands at 440.00.
You write 10 JUN OEX 450 calls at a premium of $5 each. At option expiration in June, the
OEX index is 452.00. What is your best estimate of the total equity in the portfolio after
option expiration?

ANSWER: The index rises by 2.7%. Therefore, the portfolio should rise by (1.10)(2.7%) =
2.97%.

Stock: $5 million x 1.0297 = $5,148,500

Option premium: 10 x 100 x $5 = 5,000
Cash settlement: (450 – 452) x 100 x 10 = (2,000)
$5,151,500

6. In Problem 5, suppose instead the OEX index was at 458.50 at option expiration in June.
What is your best estimate of the total portfolio equity after option expiration?

ANSWER: The index rises by 4.2%. Therefore, the portfolio should rise by (1.10)(4.2%) =
4.62%.

Stock: $5 million x 1.0462 = $5,231,000

Option premium: 10 x 100 x $5 = 5,000
Cash settlement: (450 – 458.5) x 100 x 10 = (8,500)
$5,227,500

7. How do index options simplify the process of option overwriting with large portfolios?

ANSWER: Index options require only a single option position instead of many different
individual equity options. This is much more convenient for the portfolio manager.

8. Give an example of a circumstance in which you feel writing an individual equity call option
would be preferable to writing an index option.

ANSWER: You might believe that one of the components in your portfolio is likely to behave
differently than the broad market. It might be appropriate to write a call against this stock if, for
instance, you anticipate relative weakness in the stock compared to the market averages.

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