Hedging and Option Strategies

Question 1

Call/put option contract includes

Answer 1

• company
• number of shares that can be bought/sold
• Exercise/strike price: purchase/sale price
• Expiration date: when the right to buy/sell expires

Question 2

Premium

Answer 2

Option price paid by the buyer of an option

Question 3

Options Clearing Corporation (OCC)

Answer 3

Guarantees delivery of stock if writer can’t come up with shares

Question 4

Premium determinants

Answer 4

• length of time
• SD/riskiness of underlying asset
• market price of underlying asset
• exercise/Strike Price
• risk free rate of interest: discounted present value of the exercise price varies inversely with interest rate levels; and diminishes as the length of time increases until exercised
  Cash dividend payments: price drops off on opening trade of ex-dividend date by amount of cash div, which decreases call value and increases put premium

Question 5

Synthetic positions

Answer 5

holding the underlying asset and a risk-free asset in relative amounts that vary with the market price of the underlying asset. If buying a call and selling a put on the same security with similar exercise price creates a synthetic long position

Question 6

Covered call

Answer 6

Call option against securities already own, provides downside protection while generating income

Question 7

Straddles

Answer 7

Equal number of puts and calls with same exercise price and maturity: if volatile, will buy, if stable will sell straddle

Question 8

Spreads

Answer 8

Purchase of one option and sale of another that is similar but different:
-Vertical- different exercise prices but same expiration date (strangle
-Horizontal/time/calendar- same exercise price but different expiration dates
- Diagonal- mixture of above
-Credit (generate premium income>related costs: short strangle- because premiums are received))/Debit (cost net cash outflow- long strangle because no premiums)
-Bull: Buying call option with lower strike price and selling call option with higher strike price
-Bear: Buying put option with higher strike price and selling put option with lower strike price
-Butterfly: Buying two options with different strike prices and selling two options between the two bought options (Long is profitable if stable, short is profitable if large fluctuations)

Question 9

Zero-cost collars

Question 10

Short position

Question 11

Which option strategies benefit from small movements in the underlying asset around the exercise price?

Answer 11

Short straddle and short strangle

Question 12

What are the terms for writing an option on stock that is not owned?

Answer 12

writing naked, writing against cash or writing uncovered

Question 13

Which of the option strategy is appropriate for investors that are bullish on a given security and are interested in generating income?

Answer 13

The only way to generate income from an options strategy is to function as the seller. Therefore, if the investor expects the price of the stock to increase and wants income, the only option is to sell a put.

Question 14

BIF Beets is just planting the crop for the season while the beet market is at an all time high. The company is concerned that prices will fall before their beets make it to market. What type of hedge should they enter and how is it implemented?

Answer 14

BIF Beets is long beets and needs to implement a short hedge. This is accomplished by selling a futures contract.

Question 15

An investor purchased 6 call contracts on Apple stock and paid a $9.75 premium. If the stock price is $165 per share and the exercise price is $157 per share, what is the total premium the investor paid?

Answer 15

The total premium is calculated as follows:

6 contracts x 100 shares x $9.75 = $5,850.