Question

Hedge fund/active strategies

1) A straddle trade:

A. is a volatility trade

B. is constructed by buying the asset and selling a Call option on the asset

C. both (A) and (B) are correct

2) A covered call strategy:

A. involves buying stock and buying a Call option

B. involves shorting stock and writing a Call option

C. involves buying stock and writing a Call option

3) A covered call strategy:

A. involves potentially unlimited profits

B. involves potentially unlimited losses

C. involves losses that are potentially larger than profits

4) With a protective put strategy, an advantage of selecting a low strike price for the put option is:

A. it provides stronger protection than a put with a higher strike price

B. it costs less to buy than a put option with a higher strike price

C. the cash inflow from the premium is higher than for a put option with a higher strike price

D. the maximum loss is smaller than for a put option with a higher strike price

Answer 1

1) A) is a volatility trade

Straddle involve buying of call options and put options of same strike price with same expiration period. Here trader believes there will be volatility but is unaware in which direction market will move

2) C) Involves buying stock and writing call option

Covered call strategy is meant to earn premium from writing call option. Here trader believes that stock will not go up substantially and hence call option will remain unexpired

3) C) Involves losses that are potentially larger than profits

Here maximum profit is when stock price and strike price is same at time of expiry. Thus profit is limited

Loss are possible till extend of stock price. For eg if one buy stock of $ 5. maximum loss would be 5$. Thus losses are limited but potentially are higher than profit

4) B) it costs less to buy than put option with higher strike price

Protective put involves buying a put option of stock you already own to limit it's downside. The lower the strike price of put optionThe less is premium paid for