Question

2. At a single time, a stock’s price is $10 and the premium for a call option on the stock is $3. The strike price on the option is $8. How should you explain the additional value of the premium over the difference between strike price and stock price?

   1. The stock price and option price may have been quoted at different times when stock values were different.

   2. The market value of the option premium equals the difference between the strike price and the market value of the stock.

   3. The market value of the option premium equals the difference between the stock market value and the strike price plus a time premium.

   4. The hypothetical price of the option is less than the time premium.

3. Which of the following strategies offers the greatest potential to maximize rate of return on

   a stock if the stock price rises after you implement the strategy?

   A. Purchaseastockandsupplementyourreturnbypurchasingacalloptiononthestock. B. Assume a naked position in the stock with a call option.
   C. Write a covered put on the stock.
   D. Write a naked put on the stock.

4. You speculate that the value of a stock won’t drop, and you’re unwilling to purchase the stock or pay a premium for an option. What position would you take to profit by the stock’s price not dropping?

   A. Write a put. C. Write a call.
   B. Purchase a call. D. Employ a covered position.

5. Although arbitrage presents potential profit opportunities, the likelihood of individual investors finding arbitrage opportunities is limited by

   1. the tendency for stock values to fall away from the efficient frontier.

   2. hedge strategies that combine option and stock purchases all but eliminate

      arbitrage opportunities.

   3. stock and option exchange managers, who are required to notify market makers when

      arbitrage opportunities present themselves.

   4. market makers, who are in a better position to detect and quickly capitalize before gaps

      narrow.

6. You know that leverage increases risk because

   A. leverage increases the opportunity for greater profits and losses.
   B. when you lend money to businesses, you increase your exposure to default risk. C. leverage magnifies the potential return on an investment.
   D. leverage brings with it downside risk caused by the time-limited feature of options.

Answer 1

1. At a single time, a stock’s price is $10 and the premium for a call option on the stock is $3. The strike price on the option is $8. How should you explain the additional value of the premium over the difference between strike price and stock price?

a. The stock price and option price may have been quoted at different times when stock values were different.

b. The market value of the option premium equals the difference between the strike price and the market value of the stock.

c. The market value of the option premium equals the difference between the stock market value and the strike price plus a time premium.

d. The hypothetical price of the option is less than the time premium.

The options value consists of intrinsic value and time value. For the call, intrinsic value is the difference between stock and strike price. The balance value of option is the time value, which gradually reduces, as the expiry nears

2. Which of the following strategies offers the greatest potential to maximize rate of return on a stock if the stock price rises after you implement the strategy?

a. Purchase a stock and supplement your return by purchasing a call option on the stock.

b. Assume a naked position in the stock with a call option.

c. Write a covered put on the stock.

d. Write a naked put on the stock.

If the stock price rises, you will gain on the option as well as stock. A substantial rise in stock price would generate capital gains on change in stock price + return on option (Price rise - Premium paid).

Assuming a naked position in stock with a call option would result in gains on the call. Maximum gain = Rise in the price reduced by the call premium paid.

Covered Put is the options trading strategy which involves shorting the underlying asset, along with selling a put option on the same number of shares. By doing this, the trader is able to generate income in the form of premium for writing the put option.

Writing a naked put would earn profits, if market rises, but the profit is limited to the premium received.

3. You speculate that the value of a stock won’t drop, and you’re unwilling to purchase the stock or pay a premium for an option. What position would you take to profit by the stock’s price not dropping?

a. Write a put.

b. Write a call.

c. Purchase a call.

d. Employ a covered position.

A put writer earns maximum profit, if the price doesn't go up. The writer's profit is the premium at the time of writing the Put

Writing a call gives profit to the writer, if the underlying price remains same or drops. However, if the price of underlying increases, call writer loses

Purchasing a call would earn profits, if the underlying's price goes up. But, if the price remains same, the buyer, loses the premium paid.

A covered position limits the losses, but limits the profit as well.

4. Although arbitrage presents potential profit opportunities, the likelihood of individual investors finding arbitrage opportunities is limited by

a. the tendency for stock values to fall away from the efficient frontier.

b. hedge strategies that combine option and stock purchases all but eliminate arbitrage opportunities.

c. stock and option exchange managers, who are required to notify market makers when arbitrage opportunities present themselves.

d. market makers, who are in a better position to detect and quickly capitalize before gaps narrow.

Small arbitrage opportunities exists in all markets and across the markets despite hedging and other factors. Market makers are the first to spot arbitrage opportunities. Once they spot an opportunity, the differential, which is very small and requires a huge amount of capital in order to profit, as individual investors would likely lose by the commission and other charges. Moreover, hedge strategies gradually eliminate arbitrage opportunities.

5. You know that leverage increases risk because

a. leverage increases the opportunity for greater profits and losses.

b. when you lend money to businesses, you increase your exposure to default risk.

c. leverage magnifies the potential return on an investment.

d. leverage brings with it downside risk caused by the time-limited feature of options.

Leverage increases the risk as it poses a risk of great losses (Equal to multiplier of leverage) as well as opportunities to multiply earnings.