Chapter 13 Part 12

Question 1

Call Options

Answer 1

In a call option contract, the owner has the right to exercise the contract and buy the underlying security at a specified price (the exercise or strike price). The writer has the corresponding obligation to sell the security ifthe owner exercises the call option

Question 2

Put Options

Answer 2

In a put option contract, the owner has the right to exercise the contract and sell the underlying security at a specified price (the exercise or strike price). The writer has the corresponding obligation to buy the security if the owner exercises the put option

Question 3

Listed Options To create an option, an owner and a writer need to agree on the terms of the contract. Options may be purchased either on one of the options exchanges

Answer 3

(the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), or the Pacific Stock Exchange (PSEJ), or in the over-the-counter market. Options purchased on an exchange are referred to as listed options. A key feature of listed options is that they are standardized-the terms of the contracts are set and uniform.

Question 4

Components of an Option Every listed option is characterized by the following terms: the name of

Answer 4

the underlying security, the expiration month, the exercise price, the type of option, and the premium. The premium is the market price of an option at a particular time.

Question 5

Underlying Security

Answer 5

The security underlying an option contract appears first in the description, in this case, XYZ. Each exchange-traded equity option represents the right to buy or sell one round lot (100 shares) of the underlying stock.

Question 6

Expiration Date

Answer 6

Options do not last forever. The owner can exercise his rights anytime up to the date that the option expires. In our example, the buyer may purchase 100 shares of XYZ stock from the writer until the expiration date in May. If the owner does not act by this date, the option ceases to exist. Listed options are assigned an expiration date by the exchanges on which they trade. Most stock options expire in nine months or less, but some may last as long as three years.

Question 7

Exercise (Strike) Price

Answer 7

In a call option, this is the price at which the owner is entitled to buy the underlying security. In a put option, this is the price that the owner is entitled to sell the underlying security. In our example, the owner is guaranteed a purchase price of $30 per share for XYZ stock, regardless of how high the price of XYZ rises

Question 8

Premium

Answer 8

The premium is the price the option buyer pays for the contract. This amount represents the compensation to the writer for the risk she assumes under the terms of the option contract. The writer keeps the premium regardless of whether the owner chooses to exercise the option. In our example, the buyer paid the premium of $300 ($3.00 x 100 shares).

Question 9

Equity Options In an equity option

Answer 9

common stocks are the underlying securities. Each equity option represents 100 shares of a pmticular stock

Question 10

Stock Index Options As the name suggests, the underlying securities for stock index options are

Answer 10

stock indexes. A stock index tracks the performance of a particular group of stocks or stock markets. For example, the Standard & Poor’s 500 Index tracks the performance of 500 widely
held common stocks

Question 11

Interest-Rate (Debt) Options Interest-rate options give the owners the right to buy or sell a

Answer 11

group of bonds (debt securities) at a set price. The underlying bonds are usually issued by the U.S. Treasury, but they may also be issued by smaller governmental units, such as cities and states (municipalities), or by foreign governments

Question 12

Foreign Currency Options The underlying instruments for these options are specific amounts

Answer 12

of foreign currencies. The options could be based on the euro, British pound, Swiss franc, Canadian dollar, or Japanese yen.

Question 13

Most investors use options either to

Answer 13

hedge their positions in other securities or to speculate on the direction that the market is moving. Investors who wish to hedge are attempting to protect an existing stock position. Investors may also take an option position to speculate because they feel that a stock’s price is going to move up or down

Question 14

A hedge is a way to protect against investment risks and usually involves two position

Answer 14

the security being protected and the hedging instrument. A hedge is normally set up so that if the security being protected loses value, the hedging instrument increases in value

Question 15

An investor who is bullish on a stock (thinks it will go up in value) might buy

Answer 15

call options. Buying call options allows the investor to employ leverage-to gain control of the stock for a smaller amount of money than if she purchased the stock outright. If the investor is correct and the price of the stock increases, she will profit. Theoretically, her potential profit is almost unlimited, since there is no ceiling to how high the price of the stock may rise. The investor’s risk is limited to the premium that she pays for the option plus the commission costs. If the stock does not go up in value, the call huyer can simply choose to allow the call to expire unexercised. The investor will, however, lose her entire premium, since an option is worthless once it expires

Question 16

A client purchases one STC May 30 call at a premium of 5. The underlying security increases in value to $42 per share. What is the client’s profit if she exercises the option and sells STC at its current market price?

Answer 16

If the price of STC rises and the call is exercised, the client will pay $3,000 for 100 shares ofSTC common stock (strike price of$30 x 100 shares). When the client sells the stock in the market at $42, the client will receive $4,200. The client will realize a profit of $700 (sales proceeds of $4,200 - $3,000 cost of the stock - cost of the option $500 = $700).

Question 17

An investor who sells calls is

Answer 17

bearish-he believes that the price of the underlying
stock is going to decline, or at best remain stable. There are two different types of option strategies that involve selling calls-covered call writing and uncovered (naked) call writing. An investor who sells covered calls owns tllC underlying stock, while an investor who writes uncovered calls does not own the stock.

Question 18

Selling covered calls allows investors to increase the

Answer 18

return on their portfolios while also partially protecting them against falling prices. Remember, the protection is limited to the premium received

Question 19

A client bought 100 shares of STC common stock for $100 per share. The investor believes the price of this stock is going to remain the same over the next couple of months. She writes a covered call against her stock with a strike price of $110 and a premium of $5. If the stock remains below $110 per share, what will most likely occur?

Answer 19

Generally, option sellers want the contracts to expire worthless. In this example, if the price of the stock stays the same and the call is not exercised, she will earn an additional $500 from this position ($5 x 100 shares = $500). If the stock drops in value, the premium she received also helps to reduce her losses. Assume that STC drops to $90 per share and the call is not
exercised. The stock is now worth $1,000 less than what she paid for it, but the $500 premium she received for the covered call reduces her loss from $1,000 to $500 ($1,000 - $500 = $500).
If the price of STC rises and the call is exercised, the client will receive $11,000 (strike price of$110 x 100 shares) plus the premium of $500 for a total of $11,500. Therefore, she will have received her original purchase price for the stock back ($10,000) plus a profit. The downside is that she will no longer own U1e stock, which may continue to appreciate substantially in the future.

Question 20

While selling couered calls is a relatively conservative option strategy, selling uncovered (naked) calls can be

Answer 20

a high-risk proposition. Since the writer docs not own the stock, he will need to buy the stock in the open market if the call is exercised. Theoretically, there is no limit on how high the price of the stock may rise; therefore, the writer’s potential loss is unlimited.