Chapter 4 Practice Question Answers
1. Answer: C. A covered call is an options strategy in which an investor writes a call option against a product the investor already has bought. So, in this case, a covered call is a combination of a short call and a long futures position. A covered call is considered a partial hedge. While its main purpose is to increase income, it does reduce investor risk by the amount of the premium earned.
2. Answer: D. The American-style option differs from the European style in that it can be exercised at any time, instead of just at expiration. Both styles can be traded at any time. The European-style option has lower premiums because of its reduced flexibility. Most exchange-traded stock options and most physically traded options (such as commodities) are traded in the American style.
3. Answer: C. Because Carol has written a short position, she is unable to exercise her call. Only holders of an option can exercise their position. However, she can close her position by buying a long call on the same product and the same strike price. Closing a position, trading a position, and liquidating a position are all different ways of saying the same thing.
4. Answer: D. An option’s premium is comprised of time value and intrinsic value. Intrinsic value is the amount an option is in the money, in this case $5. This is the absolute minimum your option can be.
5. Answer: B. Delta is the sensitivity of an option’s premium to a change in the price of the underlying product. For puts, delta can range between zero and minus one. With a $4 change in price and a delta of -0.45, the premium is likely to increase by roughly $1.80 (-$4 x -0.45). That would raise the premium to $4.30.
6. Answer: D. An option’s intrinsic value is the amount that it is in the money. Price volatility, economic conditions, and time to expiration are all factors that influence an option’s time value, the other component of an option’s premium.