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 – LOS a

(Notes, Practice Questions, Sample Questions)

1. Which of the following statements about put options is least accurate? The most the:

A) writer can gain is the put premium.
B) buyer can gain is unlimited. (Explanation — The most the put buyer can gain is the strike price of the stock less the premium)
C) writer can lose is the strike price less the premium.
2. A stock is trading at per share.

An investor believes that the stock will move either up or down. He buys a call option on the stock with an exercise price of $20. He also buys two put options on the same stock each with an exercise price of $25. The call option costs $2 and the put options cost $9 each. The stock falls to $17 per share at the expiration date and the investor closes his entire position. The investor’s net gain or loss is:

A) $4 gain.
B) $4 loss. (Explanation — The total cost of the options is $2 + ($9 × 2) = $20.
>At expiration, the call is worth Max [0, 17-20] = 0. Each put is worth Max [0, 25-17] = $8. The investor made $16 on the puts but spent $20 to buy the three options, for a net loss of $4)
C) $3 loss.
3. Linda Reynolds pays $2.45 to buy a call option with a strike price of $42. The stock price at which Reynolds earns $3.00 from her call option position is:

A) $47.45. (Explanation — To earn $3.00, the stock price must be above the strike price by .

00 plus the premium Reynolds paid to buy the option ($42.00+$3.00+$2.45))
B) $2.45.
C) $42.00
4. Al Steadman receives a premium of $3.80 for shorting a put option with a strike price of $64. If the stock price at expiration is $84, Steadman’s profit or loss from the options position is:

A) $3.80. (Explanation — The put option will not be exercised because it is out-of-the-money, MAX (0, X-S). Therefore, Steadman keeps the full amount of the premium, $3.80)
B) $23.80.
C) $16.20
5. Jimmy Casteel pays a premium of $1.60 to buy a put option with a strike price of $145. If the stock price at expiration is $128, Casteel’s profit or loss from the options position is:

A) $15.40. (Explanation — The put option will be exercised and has a value of $145-$128 = $17 [MAX (0, X-S)]. Therefore, Casteel receives $17 minus the $1.60 paid to buy the option. Therefore, the profit is $15.40 ($17 less $1.60))
B) $18.40.
C) $1.60
6. Suppose the price of a share of Stock A is $100. A European call option that matures one month from now has a premium of $8, and an exercise price of $100. Ignoring commissions and the time value of money, the holder of the call option will earn a profit if the price of the share one month from now:

A) decreases to $90.
B) increases to $106.
C) increases to $110 (Explanation — The breakeven point is the strike price plus the premium, or $100 + $8 = $108. Any price greater than this would result in a profit, and the only choice that exceeds this amount is $110)
7. An investor purchases a stock for $40 a share and simultaneously sells a call option on the stock with an exercise price of $42 for a premium of $3/share. Ignoring dividends and transactions cost, what is the maximum profit that the writer of this covered call can earn if the position is held to expiration?

A) $5. (Explanation — This is an out of the money covered call. The stock can go up $2 to the strike price and then the writer will get $3 for the premium, total $5)
B) $3.
C) $2.
8. An investor buys a call option that has an option premium of $5 and a strike price of $22.50. The current market price of the stock is $25.75. At expiration, the value of the stock is $23.00. The net profit/loss of the call position is closest to:

A) $4.50.
B) -$5.00.
C) -$4.50 (Explanation — The option is in-the-money by $0.50 ($23.00 – $22.50). The investor paid $5.00 for the call option, thus the net loss is –$4.50 ($0.50 – $5.00))
9. Which of the following statements regarding call options is most accurate? The:

A) call holder will exercise (at expiration) whenever the strike price exceeds the stock price.
B) breakeven point for the seller is the strike price minus the option premium.
C) breakeven point for the buyer is the strike price plus the option premium. (Explanation — The breakeven for the buyer and the seller is the strike price plus the premium. The call holder will exercise if the market price exceeds the strike price)

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