Chapter 4 Practice Question Answers
- 1. Answer: A. On long calls, an investor’s maximum gain is unlimited.
- 2. Answer: B. On long calls, an investor’s breakeven is the strike price plus the premium paid. Thus, Sally’s breakeven is 32.50 (30 + 2.50).
- 3. Answer: B. For naked short calls, the investor’s maximum gain is the premium received. In this case, Jon receives $1,050 (3 x 3.50 x 100).
- 4. Answer: C. When an investor is bullish, it means that she expects the price of the stock to rise. Investors who are bullish have long positions in a stock. They also buy calls and sell puts.
- 5. Answer: D. On short puts, an investor’s maximum gain is the strike price minus the premiums times the number of contracts times 100, which in this case is $11,000 ((30 – 2.5) x 4 x 100).
- 6. Answer: B. For puts, an option is in the money when the market price is below the strike price. In this case, the market price is above the strike price, so the option is out of the money.
- 7. Answer: B. If an investor has a long position in a stock, he can increase his income by writing calls on this stock. These are called covered calls.
- 8. Answer: C. For both long and short positions, put options are in the money when the market price is below the strike price. The intrinsic value is the amount that a stock is in the money. When an option is out of the money, the intrinsic value is always equal to $0. Because this option is out of the money, its intrinsic value is $0.
- 9. Answer: A. Investors typically hedge long positions with puts. If Jon is long 300 shares of ABC, three ABC puts will fully hedge his position.
- 10. Answer: D. When Jon opens his position, he takes in $1,050 (3 x $350). When the options are exercised, he must go into the market and buy 300 shares at 52 and immediately sell them to the holder of the call at 50 at a $600 loss. Thus, he nets $450 ($1,050 – $600).
- 11. Answer: A.