Session 17 - Reading 73 Risk Management Applications of Option Strategies

CFA Level 1 – Derivative Investments, Session 17 – Reading 73

Risk Management Applications of Option Strategies

(Notes, Practice Questions, Sample Questions)

1. An investor buys a 30 put on a share of stock for a premium of $7 and simultaneously buys a share of stock for $26. The breakeven price on the position and the maximum gain on the position are:

Breakeven price Maximum gain

1. A) $21 $11
2. B) $37 $11
3. C) $33 unlimited

<Explanation> C: To break even, the stock price should rise as high as the amount invested, $33 ($26 + $7). The maximum gain is unlimited, as the gain will be as high as the increase in the stock price

2. An investor buys a share of stock at $33 and simultaneously writes a 35 call for a premium of .
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   What is the maximum gain and loss?

Maximum Gain Maximum Loss

1. A) $5 $30
2. B) unlimited -$33
3. C) $2 -$35

<Explanation> A: The maximum gain on the stock itself is $2 ($35 ? $33). At stock prices above the exercise price, the stock will be called away from the investor. The gain from writing the call is $3 so the total maximum gain is .

If the stock ends up worthless, the call writer still has the call premium of $3 to offset the $33 loss on the stock so the total maximum loss is $30

3. The shape of a protective put payoff diagram is most similar to a:

1. A) short call.
2. B) long call.
3. C) covered call

<Explanation> B: The payoff diagram for a protective put is like that of a call option but shifted upward by the exercise price of the put

4. A covered call position is:

A) the purchase of a share of stock with a simultaneous sale of a call on that stock.

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B) the simultaneous purchase of the call and the underlying asset.

C) the purchase of a share of stock with a simultaneous sale of a put on that stock.

<Explanation> A: The covered call: stock plus a short call. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call

5. A covered call position is equivalent to:

A) owning the stock and a long call.

B) owning the stock and a long put.

C) a short put.

<Explanation> C: The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call. This is similar reasoning to selling (or going short) a put. A put is in-the-money when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay the premium and never exercise, the seller wants the price of the stock to remain above the exercise price

6. The potential profits from writing a covered call position on a stock are:

A) limited to the premium.

B) greater than the potential profits from owning the stock.

C) limited to the premium plus stock appreciation up to the exercise price.

<Explanation> C: The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call. The owner of a stock has the rights to all upside potential. The profits for a short call are limited to the premium.

For example, say that a stock owner writes a covered call at a stock price (S) of $50 and an exercise price (X) of $55 for a premium of $4. If at expiration, the price of the stock is more than $50 but less than $55, the buyer will not exercise, and the writer will “gain” the premium plus any stock appreciation between $50 and $55. If at expiration, the price of the stock is more than $55, the buyer will exercise and the writer’s gain is limited to the premium

7. The profit/loss diagram for a covered call strategy looks like what other type of profit/loss diagram?

A) Long put.

B) Short call.

C) Short put.

<Explanation> C: The profit/loss diagram for the covered call looks like the profit/loss diagram for a short put position. Both option positions have limited profit potential, with the potential loss equal to the strike price less the premium