- An investor who buys a put option is expressing a market view that is:
Answer: bearish on the underlying security.
Buying a put option gives the holder the right to sell the underlying security at a specific price. This strategy is profitable if the price of the security falls below the strike price by more than the premium paid. Therefore, an investor who buys a put is bearish, anticipating a decline in the security's price.
- The purchase of a put option can be used to protect:
Answer: a long stock position.
Buying a put option (a 'protective put') acts as insurance for a long stock position. If the stock's price falls, the investor can exercise the put to sell the stock at the higher strike price, limiting their downside loss. A short stock position is protected by buying a call option.
- In options trading, the term 'uncovered' is most commonly associated with:
Answer: option sellers.
The terms 'uncovered' (or 'naked') and 'covered' refer specifically to the status of an option seller's (writer's) position. It describes whether the writer has a corresponding position in the underlying security (or sufficient cash) to meet their obligation if the option is exercised. Option buyers do not have obligations that require covering, so these terms do not apply to them.
- An investor sells one XYZ May 80 call for a premium of $4 while owning 100 shares of XYZ stock. The stock price then declines to $70. What is the outcome for the investor?
Answer: The option expires, and the investor keeps the $400 premium.
This is a covered call. Since the stock price ($70) is below the strike price ($80), the call option is out-of-the-money and will expire worthless. The buyer will not exercise it. The investor (the seller) keeps the $400 premium they received ($4 x 100 shares), which helps offset some of the unrealized loss on their stock holding.
- The main difference between the seller of a covered call and the seller of an uncovered call is the:
Answer: level of risk assumed.
While the premium, expiration, and strike price could be identical, the key difference is the level of risk. The seller of a covered call owns the underlying stock, so their risk is limited to the potential loss on that stock. The seller of an uncovered call does not own the stock and faces unlimited risk if the stock price rises significantly.
- Compared to writing a covered call, writing an uncovered call:
Answer: has greater risk but the same profit potential.
The maximum profit for any short call position, covered or uncovered, is the premium received. However, the risk profiles are vastly different. A covered call writer's risk is the potential loss on the stock they own (minus the premium). An uncovered call writer faces unlimited risk because they would have to buy the stock in the open market at potentially any price if it rises sharply.
- Which of the following option investors has an obligation to perform if exercised?
Answer: The seller of a call
Option buyers (holders) have rights, while option sellers (writers) have obligations. The seller of a call is obligated to sell the underlying security at the strike price if the buyer chooses to exercise their right. The seller of a put is obligated to buy. Buyers of calls and puts have the right to exercise but are not obligated to do so.
- What is the maximum potential loss for an investor who buys one ABC Jul 40 put for a premium of $3?
Answer: $300
For any buyer of an option (call or put), the maximum potential loss is the amount paid for the option, which is the premium. In this case, the premium is $3 per share. Since one contract represents 100 shares, the total premium and maximum loss is $3 x 100 = $300.
- An investor who sells a put option believes the price of the underlying stock will likely:
Answer: remain stable or increase.
An investor sells (writes) a put option to receive premium income. The writer profits if the option expires worthless, which happens if the stock price stays above the strike price. Therefore, the writer of a put has a neutral to bullish outlook, believing the stock price will remain stable or rise.
- Which of the following investors would be considered to have a 'naked' option position?
Answer: An investor who sells a put on a stock they do not own and has insufficient cash to buy it.
A 'naked' or 'uncovered' position refers to a short option position that is not protected. Selling a put without having the cash to buy the stock if assigned is a naked put position. Selling a call while owning the stock (A) is covered. Selling a put with sufficient cash (B) is covered. Selling a call without owning the stock (D) is also naked, but C represents the clearest example of an uncovered position with insufficient backing.
- The primary objective of an investor who writes a covered call is to:
Answer: generate additional income from a long stock position.
Writing a covered call involves selling a call option on a stock the investor owns. The main goal of this conservative strategy is to generate income from the premium received for selling the option. It offers limited downside protection (equal to the premium) and caps the upside potential on the stock at the strike price.
- An investor buys a call option contract on a stock. This investor will profit if:
Answer: the stock price rises above the strike price by more than the premium paid.
For the buyer of a call option to realize a profit, the underlying stock price must rise above the strike price. The breakeven point is the strike price plus the premium paid. Therefore, the stock must rise above this breakeven point for the position to be profitable.
- An investor sells one ABC Jan 50 put. To be considered 'covered', the investor must:
Answer: deposit cash equal to the aggregate exercise price.
A short put is covered if the writer has sufficient cash in their account to purchase the stock at the strike price if the option is exercised. The aggregate exercise price is the strike price multiplied by the number of shares (50 x 100 = $5,000). Owning the stock covers a short call, not a short put.
- An investor writes an uncovered put option. This strategy would be profitable if the market price of the underlying stock:
Answer: increases above the strike price.
The writer of a put option receives a premium and profits if the option is not exercised. A put option will not be exercised if the market price of the stock is above the strike price at expiration. Therefore, the writer's goal is for the stock price to stay above the strike price, allowing the option to expire worthless so they can keep the entire premium.
- An investor who is bullish on a particular stock but has limited funds to invest would most likely:
Answer: buy a call option on the stock.
Buying a call option allows a bullish investor to control a large number of shares (typically 100 per contract) for a relatively small premium. This provides significant leverage and profit potential if the stock price rises, while limiting the maximum loss to the premium paid, making it suitable for an investor with limited capital.
- All of the following are true for the buyer of a call option EXCEPT:
Answer: the investor has an obligation to buy the stock.
The buyer of a call option has the RIGHT, not the obligation, to buy the stock. This is the key feature of being an option buyer. All other statements are correct: the buyer is bullish, their maximum loss is limited to the premium, and their potential gain is theoretically unlimited as the stock price can rise indefinitely.
- An investor who sells a short position in a stock for $50 per share is concerned the stock price may rise. To limit the risk on this position, the investor could:
Answer: buy a call option.
A short seller profits from a decline in a stock's price and faces unlimited risk if the price rises. Buying a call option (a protective call) provides a hedge by giving the investor the right to buy the stock at the strike price, effectively placing a ceiling on the price they would have to pay to cover their short position.
- An investor buys 100 shares of a stock at $60 and simultaneously buys one 6-month put option with a strike price of $55 for a premium of $2. What is the investor's maximum potential loss?
Answer: $700
This is a protective put strategy. The investor can lose on the stock down to the strike price of the put ($60 - $55 = $5 per share). In addition, the investor paid a premium of $2 per share for the put. The maximum loss is the difference between the stock purchase price and the strike price, plus the premium paid: ($5 + $2) x 100 shares = $700.
- A call option is different from a put option in that a call option gives the holder the right to:
Answer: buy the underlying security at a fixed price.
The fundamental difference between calls and puts lies in the action the holder can take. A call option gives the holder the right to BUY the underlying security at the strike price. A put option gives the holder the right to SELL the underlying security at the strike price.
- An investor who sells a call option without owning the underlying security is said to have a(n):
Answer: uncovered call position.
Selling a call option without owning the underlying stock is known as writing an uncovered, or naked, call. This is a high-risk strategy because if the stock price rises significantly, the writer must buy the stock in the open market at a high price to deliver it at the lower strike price, leading to potentially unlimited losses.
