Chapter 6 - Basic Features of Options

Question 1

Explain the long call options strategy.

Answer 1

The strategy

A long call gives you the right to buy the underlying stock at strike price A.

Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.

But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something. (Except for certain banking stocks that shall remain nameless.)

Options guys tips

Don’t go overboard with the leverage you can get when buying calls. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, buy one option contract (1 contract = 100 shares). If you’re comfortable buying 200 shares, buy two option contracts, and so on.

If you do purchase a call, you may wish to consider buying the contract in-the-money, since it’s likely to have a larger delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks . Try looking for a delta of .80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

The setup

• Buy a call, strike price A
• Generally, the stock price will be at or above strike A

Who should run it

Veterans and higher

When to run it

You’re bullish as a matador.

Break-even at expiration

Strike A plus the cost of the call.

The sweet spot

The stock goes through the roof.

Maximum potential profit

There’s a theoretically unlimited profit potential, if the stock goes to infinity. (Please note: We’ve never seen a stock go to infinity. Sorry.)

Maximum potential loss

Risk is limited to the premium paid for the call option.

Margin requirement

After the trade is paid for, no additional margin is required.

As time goes by

For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.

Implied volatility

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction(but you’ll hope the direction is up).

Question 2

Explain the short call options strategy.

Answer 2

The strategy

Selling the call obligates you to sell stock at strike price A if the option is assigned.

When running this strategy, you want the call you sell to expire worthless. That’s why most investors sell out-of-the-money options .

This strategy has a low profit potential if the stock remains below strike A at expiration, but unlimited potential risk if the stock goes up. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money options. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.

Options guys tips

You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the higher the strike price, the lower the premium received from this strategy.

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The setup
- Sell a call, strike price A
- Generally, the stock price will be below strike A

Who should run it

All-Stars only

When to run it

You’re bearish to neutral.

Break-even at expiration

Strike A plus the premium received for the call.

The sweet spot

There’s a large sweet spot. As long as the stock price is at or below strike A at expiration, you make your maximum profit. That’s why this strategy is enticing to some traders.

Maximum potential profit

Potential profit is limited to the premium received for selling the call.

If the stock keeps rising above strike A, you keep losing money.

Maximum potential loss

Risk is theoretically unlimited. If the stock keeps rising, you keep losing money. You may lose some hair as well. So hold onto your hat and stick to your stop-loss if the trade doesn’t go your way.

Margin requirement

Margin requirement is the greater of the following:

25% of the underlying security value minus the out-of-the-money amount (if any), plus the premium received OR 10% of the underlying security value plus the premium received

NOTE: The premium received from establishing the short call may be applied to the initial margin requirement.
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After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-contract basis. So don’t forget to multiply by the total number of contracts when you’re doing the math.

As time goes by

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

Implied volatility

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

Question 3

Explain the long put options strategy.

Answer 3

The strategy

A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short. The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock price rises.

But when you use puts as an alternative to short stock, your risk is limited to the cost of the option contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you would with short stock. You simply allow your puts to expire worthless or sell them to close your position (if they’re still worth anything).

But be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment.

Puts can also be used to help protect the value of stocks you already own. These are called protective puts.

Options guys tips

Don’t go overboard with the leverage you can get when buying puts. A general rule of thumb is this: If you’re used to selling 100 shares of stock short per trade, buy one put contract (1 contract = 100 shares). If you’re comfortable selling 200 shares short, buy two put contracts, and so on.

You may wish to consider buying an in-the-money put, since it’s likely to have a greater delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks . Try looking for a delta of -.80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

The setup

• Buy a put, strike price A
• Generally, the stock price will be at or below strike A

Who should run it

Veterans and higher

When to run it

You’re bearish as a grizzly.

Break-even at expiration

Strike A minus the cost of the put.

The sweet spot

The stock goes right in the tank.

Maximum potential profit

There’s a substantial profit potential. If the stock goes to zero you make the entire strike price minus the cost of the put contract. Keep in mind, however, stocks usually don’t go to zero. So be realistic, and don’t plan on buying an Italian sports car after just one trade.

Maximum potential loss

Risk is limited to the premium paid for the put.
Margin requirement

After the trade is paid for, no additional margin is required.

As time goes by

For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.

Implied volatility

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is down).

Question 4

Explain the short put options strategy.

Answer 4

The strategy

Selling the put obligates you to buy stock at strike price A if the option is assigned.

When selling puts with no intention of buying the stock, you want the puts you sell to expire worthless. This strategy has a low profit potential if the stock remains above strike A at expiration, but substantial potential risk if the stock goes down. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money puts. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.

Options guys tips

You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the lower the strike price, the lower the premium received from this strategy.

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The setup

• Sell a put, strike price A
• Generally, the stock price will be above strike A

Who should run it

All-Stars only

When to run it

You’re bullish to neutral.

Break-even at expiration

Strike A minus the premium received for the put.

The sweet spot

There’s a large sweet spot. As long as the stock price is at or above strike A at expiration, you make your maximum profit. That’s why this strategy is enticing to some traders.

Maximum potential profit

Potential profit is limited to the premium received for selling the put.

Maximum potential loss

Potential loss is substantial, but limited to the strike price minus the premium received if the stock goes to zero.

Margin requirement

Margin requirement is the greater of the following:

25% of the underlying security value minus the out-of-the-money amount (if any), plus the premium received OR 10% of the underlying security value plus the premium received

NOTE: The premium received from establishing the short put may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-contract basis. So don’t forget to multiply by the total number of contracts when you’re doing the math.

As time goes by

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

Implied volatility

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

Question 5

Explain the covered call options strategy.

Answer 5

The strategy

Selling the call obligates you to sell stock you already own at strike price A if the option is assigned.

Some investors will run this strategy after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit.

Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless.

If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.

Options guys tips

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility .
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You may wish to consider selling the call with a premium that represents at least 2% of the current stock price (premium ÷ stock price). But ultimately, it’s up to you what premium will make running this strategy worth your while.
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Beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock. Remember, if something seems too good to be true, it usually is.

The setup

• You own the stock
• Sell a call, strike price A
• Generally, the stock price will be below strike A

Who should run it

Rookies and higher

When to run it

You’re neutral to bullish, and you’re willing to sell stock if it reaches a specific price.

Break-even at expiration

Current stock price minus the premium received for selling the call.

The sweet spot

The sweet spot for this strategy depends on your objective. If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it.

If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned.

However, you probably don’t want the stock to shoot too high, or you might be a bit disappointed that you parted with it. But don’t fret if that happens. You still made out all right on the stock. Do yourself a favor and stop getting quotes on it.

Maximum potential profit

When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call.

Maximum potential loss

You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.

Margin requirement

Because you own the stock, no additional margin is required.

As time goes by

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

Implied volatility

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

Question 6

Explain the cash-secured put options strategy.

Answer 6

The strategy

Selling the put obligates you to buy stock at strike price A if the option is assigned.

In this instance, you’re selling the put with the intention of buying the stock after the put is assigned. When running this strategy, you may wish to consider selling the put slightly out-of-the-money . If you do so, you’re hoping that the stock will make a bearish move, dip below the strike price, and stay there. That way the put will be assigned and you’ll end up owning the stock. Naturally, you’ll want the stock to rise in the long-term.

The premium received for the put you sell willl ower the cost basis on the stock you want to buy. If the stock doesn’t make a bearish move by expiration, you still keep the premium for selling the put. That’s sort of nice, because it’s one of the few instances when you can profit by being wrong.
Options guys tips

Don’t go overboard with the leverage you can get when selling puts. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, sell one put contract (1contract = 100 shares). If you’re comfortable buying 200 shares, sell two put contracts, and so on.

The setup

Sell a put, strike price A
Keep enough cash on hand to buy the stock if the put is assigned
Generally, the stock price will be above strike A

Who should run it

Rookies and higher

NOTE: Cash-secured puts can be executed by investors at any level. The Rookie’s Corner suggests other plays more suited to beginning options traders.
When to run it
Options Playbook image 3Options Playbook image 1

You’re slightly bearish short-term, bullish long-term.
Break-even at expiration

Strike A minus the premium received for the put.
The sweet spot

You want the stock price to be just below strike A at expiration. Remember, the goal here is to wind up owning the stock.
Maximum potential profit

Potential profit is limited to the premium received from selling the put. (If the puts are assigned, potential profit is changed to a “long stock” position.)
Maximum potential loss

Potential loss is substantial, but limited to the strike price if the stock goes to zero. (If the puts are assigned, potential loss is changed to a “long stock” position.)
Margin requirement

You must have enough cash to cover the cost of purchasing the stock at the strike price.

NOTE: The premium received from establishing the short put may be applied to the initial margin requirement.
As time goes by

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
Implied volatility

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

Question 7

What is implied volatility?

Answer 7

The volatility implicit in an option’s
premium.

Question 8

What is historical volatility?

Answer 8

Past or historical volatility of an
underlying asset, measured by taking
the standard deviation of price changes
over a set period of time.

Question 9

What is delta?

Answer 9

Definition: Delta measures how much the price of an option is expected to move with a $1 change in the underlying stock.

• Calls: Positive delta (0 to 1). If the stock price increases by $1, the call price increases by the delta amount. For example, if a call has a delta of 0.50 and the stock goes up $1, the call’s price increases by $0.50.
• Puts: Negative delta (-1 to 0). If the stock price increases by $1, the put price decreases by the delta amount. For example, if a put has a delta of -0.50 and the stock goes up $1, the put’s price decreases by $0.50.
• At-the-money Options: Typically have a delta around 0.50.
• In-the-money Options: As expiration nears, delta approaches 1 for calls and -1 for puts.
  
  • Out-of-the-money Options: Delta approaches 0 as expiration nears.

Takeaway: Delta indicates how much an option’s price will change with a $1 change in the stock price. It also gives a rough probability of the option ending up in-the-money at expiration.

Question 10

What is gamma?

Answer 10

Definition: Gamma measures the rate of change of delta for a $1 change in the stock price.

• High Gamma: Indicates more responsiveness to stock price changes.
• At-the-money Options: Have the highest gamma.
• Near-term Options: Show more significant gamma effects compared to longer-term options.

Takeaway: Gamma reflects how delta changes with stock price movements. High gamma can benefit option buyers if their forecast is correct, but it poses risks if their forecast is wrong. For option sellers, high gamma can be dangerous if the stock moves against their position.

Question 11

What is theta?

Answer 11

Definition: Theta measures the rate of time decay of an option’s price.

• Time Decay: Options lose value as they approach expiration, with at-the-money options experiencing the most significant dollar loss.
• At-the-money Options: Have the most time value and hence the highest theta.
• Out-of-the-money Options: Lose value percentage-wise more rapidly due to lower time value.

Takeaway: Theta is a crucial consideration for option buyers and sellers. Option buyers face the challenge of time decay, while sellers benefit from it as the options they sold lose value over time.

Question 12

What is vega?

Answer 12

Definition: Vega measures the sensitivity of an option’s price to changes in implied volatility.

• Implied Volatility: As it increases, the value of options increases because of the potential for larger stock movements.
• Short-term vs. Long-term Options: Longer-term options have higher vega, meaning their prices are more sensitive to changes in implied volatility.

Takeaway: Vega is important for understanding how volatility affects option pricing. An increase in implied volatility increases the option’s price, benefiting option holders, while a decrease in implied volatility reduces the option’s price.

Question 13

What is rho?

Answer 13

Definition: Rho measures the sensitivity of an option’s price to changes in interest rates.

• Call Options: Positive Rho. If interest rates increase by 1%, the price of call options increases.
• Put Options: Negative Rho. If interest rates increase by 1%, the price of put options decreases.

Impact:

• Short-term Options: Minimal effect from interest rate changes.
• Long-term Options (LEAPS): Significant impact due to greater time value component.

Takeaway: Rho is crucial for understanding the effect of interest rate changes, especially for long-term options. It’s less significant for short-term options but becomes important for advanced traders managing long-term positions.

Question 14

What is an American-style option?

Answer 14

A type of option that can be exercised
at any time up to the expiration of the
option.

Question 15

What does it mean to be assigned?

Answer 15

When an option holder exercises, the
writer is assigned to either buy or sell
the underlying asset.

Question 16

What does it mean when an option is at-the-money?

Answer 16

When the exercise price of either a
put or a call option is the same as the
market price of the underlying asset.

Question 17

What does it mean when an option is covered?

Answer 17

When an investor writes an option and
has an underlying asset position that
would satisfy the obligation in case of
assignment.

Question 18

What is a European-style option?

Answer 18

A type of option that can only be
exercised at expiration.

Question 19

What does it mean for an option to be in-the-money?

Answer 19

The amount of intrinsic value an option
has. A call option is in-the-money if
the market price of the underlying
asset is higher than the exercise price.
A put option is in-the-money if the
market price is lower than the exercise
price.

Question 20

What is intrinsic value of an option?

Answer 20

For a call option, intrinsic value is
calculated by subtracting the exercise
price from the market price. For a put
option, intrinsic value is calculated by
subtracting the market price from the
exercise price. For both calls and puts,
intrinsic value cannot be less than zero.

Question 21

What does it mean for an option to be out-of-the-money?

Answer 21

A call option is considered out-of-
the-money if the market price of
the underlying asset is lower than
the exercise price. A put option is
considered out-of-the-money if the
market price is higher than the exercise
price.

Question 22

What is time value of an option?

Answer 22

The premium of the option less its
intrinsic value.

Question 23

What is a trading unit?

Answer 23

The size of the asset underlying
the derivative contract. All North
American-listed equity options, for
example, have a trading unit of 100
shares of the underlying stock.

Question 24

What does it mean for an option to be uncovered?

Answer 24

When an investor writes an option
without having an underlying position
that would satisfy the obligation in
case of assignment.

Question 25

Discuss the history of options trading.

Answer 25

Equity options were available OTC only, from the early 1900s until the opening of the CBOE in 1973. The
Montreal Exchange was the first exchange to list options for trading in Canada in 1975.

Question 26

Define and describe the importance of key option terms.

Answer 26

Options are contracts between a buyer, or holder, and a seller, or writer. The holder of the option is said to be
long the option and the writer is said to be short the option.
Holders of call options have the right, but not the obligation, to buy the underlying asset from the writer within
a specified period of time that ends on the expiration date. Holders of put options have the right to sell the
underlying interest. The price at which option holders can buy or sell the underlying asset as part of the option
contract is referred to as the exercise, or strike, price.
To enforce the terms of the contract, option holders must exercise the option. This is an instruction to the writer
of the option to sell (in the case of a call) or buy (in the case of a put) the underlying asset to or from the option
holder at the strike price.
Buyers of options pay writers a premium. The size of the premium is determined in a competitive marketplace
and takes into account a number of different factors.
An exchange-traded option’s trading unit represents the standardized size of the underlying interest. All equity
options in North America have 100 shares of the underlying stock as their underlying interest. Other types of
options have various trading units.
Options that can be exercised at any time up to and including the expiration date are called American-style
options. All equity options traded in North America are American-style options. Options that can be exercised
only at expiration are called European-style options. Most, but not all, stock index options are European-style
options.
A new option position (either long or short) is established by way of an opening transaction. A closing
transaction (selling a long position or buying back a short position) in the same option contract is required to
offset any rights or obligations associated with a position established as part of an opening transaction.
Option premiums can consist of intrinsic value and time value. Intrinsic value is the tangible worth of an option
and cannot be less than zero. Any excess of the premium over the intrinsic value is time value. A call option’s
intrinsic value is defined as the underlying asset price minus the call option’s strike price. A put option’s intrinsic
value is defined as the put option’s strike price minus the underlying asset price. The time value of both calls and
puts is defined as the option premium minus intrinsic value.
If an option has positive intrinsic value, it is in-the-money. Option holders will only consider exercising an option
if it is in-the-money. It would not make financial sense to do so otherwise. Call options are in-the-money when
the price of the underlying asset is higher than the call’s strike price. Put options are in-the-money when the
price of the underlying asset is lower than the put’s strike price. When an option’s (call or put) strike price is
equal to the underlying asset’s price, it is considered to be at-the-money. Finally, when a call option’s strike price
is above the underlying asset’s price, it is considered out-of-the-money. Put options are out-of-the-money when
the underlying asset is trading above the put’s strike price.

Question 27

List and explain why options are purchased.

Answer 27

• Leverage
  Options give purchasers the opportunity to achieve large profits on a relatively small investment because the
  premium paid for options is usually only a fraction of the price of the underlying interest.
• Limited risk
  Option buyers know that the most that can be lost is the cost of the option premium because they have the
  right to let the option expire without taking any further action.

Question 28

List and explain why options are written

Answer 28

• Additional income
  Options are primarily written to collect the premium income received when they are written.

Question 29

List and explain the advantages of exchange-traded options versus OTC options.

Answer 29

Exchange-traded options have the same advantages over OTC options as exchange-traded forwards
(i.e., futures) have over OTC forwards. Specifically, exchange-traded options offer:
- a third-party guarantor;
- increased liquidity;
- more comprehensive disclosure and surveillance rules; and
- price transparency.

Question 30

XYZ stock is trading at $51 and XYZ 50 puts are trading at $3. How much time value is built into the price of
the XYZ 50 puts?
a. $0
b. $1
c. $2
d. $3

Answer 30

d. $3
The put is out-of-the-money because the strike price is lower than the current market price of XYZ stock.
All of the premium is time value.

Question 31

ABC stock is trading at $59 and ABC 60 calls are trading at $2. What is the intrinsic value of the ABC 60 calls?
a. $0
b. $1
c. $2
d. $3

Answer 31

a. $0
This option is also out-of-the-money. Therefore the intrinsic value is zero

Question 32

DEF 80 call options are trading at $3.50. For these options to be considered in-the-money, at what price must
DEF stock be trading?
a. At any price above $80
b. At any price below $80
c. At any price above $83.50 only
d. At any price below $76.50 only

Answer 32

a. At any price above $80.
Definitions of the in-, at- or out-of-the-money depend on the relationship between the underlying price
and the strike price only. The size of the premium does not matter.

Question 33

What is the primary difference between an American-style option and a European-style option?

Answer 33

The primary difference is the time frame during which they can be exercised. European-style options can be
exercised only at maturity, while American-style options can be exercised at any time up to and including
maturity.

Question 34

A speculator wrote 5 CEB 60 call options at $2. Two weeks later, CEB common stock is trading at $63, and
the speculator liquidates the calls at a price equal to their intrinsic value plus $0.50 of time value. What is
the speculator’s profit or loss on the transactions?
a. $750 loss.
b. $150 loss.
c. $350 profit.
d. $750 profit.

Answer 34

a. $750 loss.
($2 − $3.50) × 100 × 5
The calls were bought back at $3.50. With the stock trading at $63, the 60 calls had $3 of intrinsic value
and $0.50 of time value

Question 35

A speculator is short 5 GHI 40 puts. With GHI stock trading at $35, the speculator is assigned on
the five options. What will occur as a result of the assignment?
a. The speculator will buy 500 shares of GHI and pay $17,500.
b. The speculator will buy 500 shares of GHI and pay $20,000.
c. The speculator will sell 500 shares of GHI and receive $17,500.
d. The speculator will sell 500 shares of GHI and receive $20,000.

Answer 35

b. The speculator will buy 500 shares of GHI and pay $20,000.
An assigned writer of puts will have to buy the underlying asset at the strike price

Question 36

Why is the risk for a buyer of a put or a call limited to the premium paid?

Answer 36

Buyers of options have rights, not obligations. If the owner of an option does not want to exercise it, they may
let the option expire and they will forfeit only the premium originally paid to buy the option.

Question 37

Why is the risk for a naked call option writer unlimited?

Answer 37

The risk for a naked call option writer is unlimited because the price of the underlying security could rise
infinitely before the option expires. If it does, the owner of the call will exercise and the writer will be forced
to buy the stock in the open market at the infinitely high price and then turn around and sell it at the exercise
price.

Question 38

How does the risk and reward from buying an equity call option compare to the risk of buying the underlying
stock?

Answer 38

Both have limited risks and unlimited potential rewards. The risk of a long call is limited to the premium paid
for the option. This can never exceed the price of the stock, so it entails less risk. However, the potential reward
of a long call option position is lower than the potential reward from owning the underlying stock by the
amount of the premium paid.

Question 39

A speculator is trying to decide whether she should sell a stock short or write call options on the stock. The
stock is currently trading at $50, and she is interested in the May 50 calls on the stock that are currently
trading at $3.
How does the risk and reward potential of short selling the stock at $50 compare with that of selling May 50
call options at $3?
a. The short selling alternative has more risk and a greater reward.
b. The short selling alternative has more risk and a smaller reward.
c. The short selling alternative has less risk and a smaller reward.
d. The short selling alternative has less risk and a greater reward.

Answer 39

a. The short selling alternative has more risk and a greater reward.
Both options have an unlimited risk potential and a limited reward. The risk of a short call is lower than the
short stock position by the premium received from writing the option. The reward for a short call is limited
to the premium received, while the short seller’s reward is limited to the price at which the stock was sold
short.

Question 40

What are the risks and rewards of being outright short or outright long in an equities position?

Answer 40

Outright Long Position (Buying and holding a stock)

Rewards:

Capital Appreciation: If the stock price increases, you can sell at a higher price than you bought, realizing a profit.
Dividends: Some stocks pay dividends, providing regular income in addition to potential price appreciation.
Limited Losses: The maximum loss is limited to the amount invested, as the stock price cannot go below zero.
Ownership Benefits: Being a shareholder may provide voting rights and other benefits associated with ownership in the company.

Risks:

Market Risk: The stock price can decline due to market conditions, leading to potential losses.
Company-Specific Risk: Poor performance, management decisions, or other issues specific to the company can negatively impact the stock price.
Opportunity Cost: Capital tied up in the stock could potentially earn better returns elsewhere.
Liquidity Risk: If the stock is not easily tradable, it might be difficult to sell quickly without affecting the price.

Outright Short Position (Selling a stock you don’t own, intending to buy it back later at a lower price)

Rewards:

Profit from Decline: If the stock price declines, you can buy it back at a lower price, realizing a profit.
Hedging: Short positions can be used to hedge against other investments or overall market declines.
Leverage: Short selling can amplify potential returns, as it often involves borrowing shares.

Risks:

Unlimited Losses: Unlike long positions, the potential losses in short selling are theoretically unlimited because the stock price can keep rising indefinitely.
Margin Requirements: Short selling typically requires a margin account, and the broker may require additional capital if the position moves against you (margin calls).
Borrowing Costs: There are costs associated with borrowing the stock to sell short, including interest and fees.
Market Timing: Successfully short selling requires precise timing, as markets generally trend upwards over the long term.
Short Squeezes: If many investors are shorting a stock, any positive news can trigger a rapid increase in the stock price, forcing short sellers to buy back shares at higher prices, amplifying losses.