Chapter 15: Options

Question 1

How is an option a “derivative” security?

Answer 1

its value is “derived” from the value of the underlying asset.

Question 2

Call Option

Answer 2

a contract that gives buyer the right to buy the underlying asset at strike price before expiration

Question 3

Put Option

Answer 3

a contract that gives buyer the right to sell the underlying asset at strike price before expiration

Question 4

Standardized Option Expiration Date

Answer 4

last day that an option can be exercised, this is the 3rd Friday of expiration month

Question 5

European Options

Answer 5

can only be exercised on expiration day

Question 6

American Options

Answer 6

can be exercised any time on or before expiation day

Question 7

What are examples of organized option exchanges for standardized contracts?

Answer 7

CME Group (US)
Montreal Exchange (Canada)

Question 8

Options Clearing Corporation (OCC)

Answer 8

guarantees the option writer’s performance in the US market

Question 9

Canadian Derivatives Clearing Corporation (CDCC)

Answer 9

the clearing agency for all derivatives exchanges in Canada (Montreal and Winnipeg). Brokerage firms merely act as intermediaries between investors and the CDCC.

Question 10

In-the-money option

Answer 10

An option that would yield a positive payoff if exercised

Question 11

Out-of-the-money option

Answer 11

An option that would NOT yield a positive payoff if exercised

Question 12

At-the-money

Answer 12

stock price (S) and strike price (K) are equal

Question 13

Option payoff

Answer 13

the value of an option at expiration for an European option. An option buyer can realize the option payoff by exercising the option

Question 14

Option premium (or option price)

Answer 14

the cost to buy the option.

Question 15

Option Profits

Answer 15

calculated by subtracting the option premium from the option payoff

Question 16

Protective Put

Answer 16

Position: buy a stock and at-the-money put (S+P)
Objective: maintain unlimited upside potential with limited downside risk (buy the put as an insurance)

Question 17

Covered Call

Answer 17

Position: own a stock and write a call (S - C)
Objective: Earn the call premium during low volatility period

Question 18

Naked Call

Answer 18

Writing a “naked” call means writing a call option without holding the underlying stock.
The loss could be unlimited.

Question 19

Straddle

Answer 19

Long Straddle: buy at-the-money call and at-the-money put on the same stock, with same expiration date and same strike price (C+P) Objective: buy a straddle when expecting large swings from strike price. The strategy will fail if there is no movement in stock price, and the options expire worthless. The buyer will lose the option premiums.
Short straddle: write a straddle for earning the option premiums when expecting no dramatic stock price movement from strike price -(C+P)

Question 20

Spreads

Answer 20

A combination of two or more calls or puts with differing strike prices or expiration days
Use when stocks are expected in a trading range on the upside

Question 21

Bear money spread

Answer 21

buy a put and write a put (further out of money). Use when stocks are expected in a trading range on the downside

Question 22

Put-Call Parity

Answer 22

the difference between the call price and the put price equals to the difference between the stock price and the discounted strike price.

Question 23

Stock index option

Answer 23

option on a stock market index

Question 24

Intrinsic value

Answer 24

the payoff that option holders receive when the option is exercised

Question 25

Call Option Intrinsic Value

Answer 25

max [0, S – K ]. In words: The call option intrinsic value is the maximum of zero or the stock price minus the strike price.

Question 26

Put Option Intrinsic Value

Answer 26

max [0, K – S ]. In words: The put option intrinsic value is the maximum of zero or the strike price minus the stock price

Question 27

Time Value

Answer 27

Option price - Intrinsic value

Question 28

Selling a call on a share of stock you already own is a _______.

A. covered call
B. protective call
C. spread
D. straddle
E. strap

Answer 28

A. covered call

Question 29

Put-call parity is the relationship between the \_\_\_\_ of a call and a put for a European style option with identical exercise date and strike price.
A. market price
B. intrinsic value
C. break-even price
D. premium value
E. expiration value

Answer 29

A. market price

Question 30

You purchased one Alcan March 50 put and sold one Alcan March 45 put.  Your strategy is known as 
A. a straddle
B. a cap
C. a collar
D. a spread
E. non of the above

Answer 30

D. a spread

Question 31

The primary purpose of a protective put is
A. the increase in potential gains
B. the guarantee of a higher return
C. the elimination of downside risk
D. the receipt of the option premium
E. the increase in risk and thus an inccrease in returns

Answer 31

C. the elimination of downside risk