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Trading Options - Chapter Seven Questions

Filed Under Beginner Options Trading 

In the Long Run, Covered Calls Are Less Risky
There are some studies that have shown where covered calls have produced superior returns to the market while reducing downside risk, which seems to go against the premise of the risk-reward tradeoff. But these studies are considering shorter time periods when the markets are relatively flat and, in these times, covered calls will outperform the market. But it’s a myth that they will always outperform the market while reducing your risk, which is what these studies lead many to believe. They are not taking into account the “homeruns” that stocks sometimes hit during good markets, and covered call writers will not participate in these to the same degree as long stock holders. In the long run, covered call writing is more conservative than owning stocks. As stated before, this doesn’t mean that there won’t be situations where the covered call writer outperforms the long stock holder. We just mean that you cannot consistently reduce your risk and increase your returns over time.
 
Despite this fact, covered call writing can be a very lucrative and rewarding strategy. In fact, in 2002, the CBOE created a buy-write index (BXM), which shows how a portfolio of covered calls would have performed over a given time period by writing slightly out-of-the-money calls against the S&P 500 Index. At certain times, the BXM can boast some pretty impressive results. Covered calls are also a good strategy that can be combined with other strategies; they do not need to be used as an independent strategy.
 
For example, rather than buying shares of stock, you could start by selling naked puts as a way to acquire the stock. Remember, if you sell a put, you create the potential obligation to buy stock. Selling naked puts is not a strategy that we will cover, but we’re just trying to make the point of how option strategies can be used in conjunction with one another. Continuing, once the stock is acquired, you could then write calls as a way to sell the stock. By adding the additional step of selling puts, the investor acquires at least two option premiums – one to buy the stock and one to sell the stock. He may acquire more if he’s able to write additional puts to acquire the stock and additional calls to sell the stock.
 
So while covered calls may be presented as a basic strategy, don’t think that experienced investors do not use them. They can be very powerful when combined in the right ways for specific situations. As with any strategy, there are many ways to fine-tune them to suit your needs. The important thing is that you understand the basics. Once you do, you’ll find that covered calls may not be so basic after all.
 
Key Concepts
1)    Covered calls are created by selling calls in a 1:1 ratio against your long stock.
2)    The covered call strategy is a neutral to slightly bullish outlook.
3)    The risk of a covered call is that the stock price falls.
4)    Covered calls are synthetically equivalent to naked puts. If you would not write a naked put on a particular stock then you should not use a covered call either.
5)    Do not expect to get assigned (called out) of a covered call early. If you do, it only helps the position since you receive the maximum reward early.
6)    You can buy stock and sell calls simultaneously with a buy-write.
7)    In the long run, covered calls must be more conservative than long stock.
 
Chapter Seven Questions
 
1) You own 300 shares of ABC stock, trading for $60, and have written 3 $65 calls. You have the:
a) Right to buy 300 shares of ABC for $65
b) Obligation to buy 300 shares of ABC for $65
c) Right to sell 300 shares of ABC for $65
d) Obligation to sell 300 shares of ABC for $65
 
2) You purchased 200 shares of stock at $40 and have written two $40 calls for $1. Your cost basis on the stock is effectively:
a) $39
b) $41
c) $38
d) Cannot be determined
 
3) You have written 4 $50 call options against your stock. How much money will you receive if you are assigned?
a) $200
b) $5,000
c) $2,000
d) $20,000
 
4) The risk of a covered call is that:
a) You might have to give up your stock at a very unfavorable price
b) The stock price falls
c) The premium of the short call falls
d) The stock price stays the same
 
5) Covered call writers should:
a) Only write short-term calls since they are exposed to the sharpest time decay
b) Write the month that brings in an adequate premium relative to the risk.
c) Never write out-of-the-money calls
d) Never write in-the-money calls
 
6) Assuming you are not looking for highly-speculative investments, one of the most important standards for selecting stocks to write calls against is for you to:
a) Write calls that have large premiums
b) Write calls against stock that you are comfortable holding
c) Write calls on highly-volatile stocks
d) Write calls only on long-term options
 
7) If you write a covered call and the stock’s price rises above the strike price prior to expiration, you should:
a) Expect to get assigned on the ex-date
b) Expect to get assigned the following day
c) Expect to get assigned that day
d) Only expect to get assigned at expiration if the stock’s price is still above the strike
 
8) You have written a $50 call against your stock, which is trading for $57 with 20 days remaining until expiration. If you decide to buy back the $50 call and simultaneously sell the $55 call (same expiration), what is this called and will is produce a net credit or debit?
a) Roll-up, net credit
b) Roll-up, net debit
c) Roll-down, net credit
d) Roll-down, net debit
 
9) You bought 200 shares of ABC stock for $30 and have written two calls against it for $1 each. The calls have expired worthless and you wish to write calls again for the following month. However, the stock has now dropped to $25 so you decide to write two $25 calls for $2 each. What is your new cost basis and what is your profit or loss if you are assigned?
a) $30 cost basis, $5 loss
b) $27 cost basis $2 loss
c) $24 cost basis, $1 loss
d) $24 cost basis, $1 profit
 
10) You bought 1,000 shares of XYZ stock for $20 and wrote 10 $20 calls for $2. At expiration, the stock is trading for $15. What is your unrealized profit or loss at this point?
a) $2 gain
b) $2 loss
c) $3 gain
d) $3 loss
 
11) You bought 100 shares of ABC stock for $50 and wrote the $50 call for $1. At expiration, the stock is trading for $55 and the call is trading at parity (worth the $5 intrinsic value). If you buy the call to close:
a) You will be left with a loss since you sold the call for $1 and bought it back for $5.
b)You will have a $1 gain
c) You will have a $5 loss
d) You will just break even
 
12) If you write a covered call, you:
a) Can always exit it by purchasing the call back
b) Must remain in the covered call until expiration
c) Can exit the position by exercising the call
d) Can exit the position by selling a put
 
13) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your static return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 5.8%
 
14) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your breakeven return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 4.8%
 
15) You bought 100 shares of ABC for $70 and wrote the $70 call for $3. What is your return if exercised?
a) 5.9%
b) 3.2%
c) 6.2%
d) 4.5%
 
16) If you write an in-the-money call against your shares, you:
a) Can only make the risk-free rate as a maximum return
b) Are guaranteed to make money on the position
c) Cannot make money on this position
d) Can make money as long as a time premium is present
 
17) In the long run, covered calls must be:
a) More risky due to the added risk of the short call
b) More risky due to the downside risk of the stock
c) More conservative and therefore have lower returns
d) More conservative and therefore have higher returns
 
18) Buy-writes are orders that are used primarily to:
a) Increase execution risk
b) Eliminate execution risk
c) Increase your cost basis
d) Increase the breakeven point
 
19) You purchased 100 shares of XYZ for $50 and sold a one-month $50 call for $2. The stock is $53 at expiration and you are assigned on the call. What is your ANNUALIZED rate of return?
a) 30%
b) 40%
c) 50%
d) 60%
 
20) What is the rationale for the covered call strategy?
a) To make lower returns by increasing risk
b) To make higher returns by lowering risk
c) To make higher returns by increasing risk
d) To make more consistent returns and allow compounding to work for you

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