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Trading Options - Chapter Seven Answers

Filed Under Beginner Options Trading 

Trading Options - Chapter Seven Answers
 
1) You own 300 shares of ABC stock, trading for $60, and have written 3 $65 calls. You have the:
d) Obligation to sell 300 shares of ABC for $65
Writing calls creates the potential obligation to sell your shares for the strike price. It is a potential obligation because you’re only required to if the short call exercises. You can also get out of the obligation by buying the $65 call to close.
 
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
Because you wrote a contract equivalent number of calls against your shares, the premium can just be subtracted from the cost in order to find the cost basis. In this example, you paid $40 for the stock and received $1 from selling the call, which means your cost basis is $39. We can show this another way too. You paid 200 shares * $40 = $8,000 for the stock and received 2 contracts * $1 = $200 for the options, which makes your total cash outlay $7,800. Because you own 200 shares, your average cost is $7,800/200 = $39 per share.
 
3) You have written 4 $50 call options against your stock. How much money will you receive if you are assigned?
                d) $20,000
If assigned, you will sell 400 shares for the $50 strike, which makes the total you will receive equal to $20,000.
 
4) The risk of a covered call is that:
b) The stock price falls
The risk of a covered call is that the stock falls. Giving up your stock at an unfavorable price is a missed opportunity but certainly not a risk of principal.
 
5) Covered call writers should:
                b) Write the month that brings in an adequate premium relative to the risk.
All else constant, short-term calls are good to write for many reasons. But you must remember that all strategies are tradeoffs between risk and reward. Short-term options do decay faster, but they do not bring in as much premium as longer-term options. It is up to the investor to find the right mix of premium and time so that he feels he is fairly compensated for the risk.
 
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:
b) Write calls against stock that you are comfortable holding
If you are willing to hold the stock regardless of whether options are traded or not, then you are willing to assume the downside risk. Writing calls with this mindset means that the calls are generating income and reducing your downside exposure, which makes it a less risky position.
 
7) If you write a covered call and the stock’s price rises above the strike price prior to expiration, you should:  
d) Only expect to get assigned at expiration if the stock’s price is still above the strike
No matter where the stock price may be, it is not in the long call holder’s best interest to exercise early. While it can happen, you shouldn’t expect to get assigned early.
 
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?
b) Roll-up, net debit
You are rolling up from the $50 strike to a $55 so this is a roll-up. Because you’re buying back the lower strike price (more valuable strike) that means you will spend more money than you receive, which makes the trade a net debit. This trade will increase the cost basis of your long stock position but will also increase your potential selling price from $50 to $55.
 
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?
b) $27 cost basis, $2 loss
Your original cost basis is $30 - $1 = $29. If you roll down to the $25 strike, you will receive $2 for it, which makes your new cost basis $27. However, by rolling down the strikes, you’re also getting less money from the sale of the stock if you should get assigned. Your cost basis is $27 but you’d only receive $25 if assigned, which potentially locks you into a $2 loss. It’s not a loss at this point as you could roll up to a higher strike at a later date. But if you were assigned at this point, you’d have a $2 loss.
 
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?
d) $3 loss
Your cost basis is $18 (paid $20 and received $2 for the calls) and the calls are worthless so you have no obligation to sell your stock. However, with the stock at $15, you are currently in a $3 loss if you should sell the stock for the current $18 stock price. This example shows that the risk of a covered call is that the stock falls.
 
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:
                d) $3 loss
When you purchased the shares for $20 and wrote the calls for $2, your cost basis was $18 and you had the potential obligation to sell your shares for $20 at expiration. With the stock at $15 at expiration, you have a $3 unrealized loss at that point. In other words, because you effectively paid $18, if you sold those shares for the current market value of $15, you’d have a $3 loss.
 
12) If you write a covered call, you:
a) Can always exit it by purchasing the call back
You can always escape your obligations of a covered call (or of any option position for that matter) by entering a reversing trade. For the covered call, this means you would have to buy back the call since you originally sold it.
 
13) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your static return?
c) 7.1%
If you pay $30 for the stock and write the $30 call for $2, your cost basis is $28. The static return is measured assuming the stock is the same price at expiration, which is the current value of $30. So if you were to sell the stock at that moment, you’d have a gain of $2/$28 = 7.1%.
 
14) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your breakeven return?
b) 6.7%
You purchased shares for $30 and wrote the $30 call for $2, which makes your cost basis $28. This means the stock can fall from its current price of $30 down to your cost basis of $28, or 6.7%, and you’d just break even on the trade.
 
15) You bought 100 shares of ABC for $70 and wrote the $70 call for $3. What is your return if exercised?
d) 4.5%
You bought shares for $70 and wrote the $70 call for $3 so your cost basis is $67. If the long position exercises, you will sell your shares for the strike price of $70, which means your return is $3/$67 = 4.5%.
 
16) If you write an in-the-money call against your shares, you:
d) Can make money as long as a time premium is present
If you write an in-the-money call against your long stock position, you can still make money on the trade as long as the call has some time premium. For example, if you buy shares at $50 and write a $45 call for $6, then there is $1 time value on the call and that is the amount you could make by selling this call. Your cost basis would be $44 and you’d have the potential obligation to sell your shares for $45. The only time you cannot make money by selling an in-the-money call is if the option is trading at parity (exactly for the intrinsic amount). In this example, if the $45 call was trading for $5, then selling this call makes your cost basis $45 and you’d have the potential obligation to sell your shares for $45.
 
17) In the long run, covered calls must be:
c) More conservative and therefore have lower returns
Covered calls have less risk than a long stock position for the fact that you are reducing your downside risk by selling the call. If you have less risk, you must have lower returns. Again, this does not mean that a covered call writer cannot beat the long stock position in certain markets. But overall it is a less risky position and will have lower returns for the market as a whole.
 
18) Buy-writes are orders that are used primarily to:
b) Eliminate execution risk
Buy-writes allow you to simultaneously buy the stock and sell the call. This prevents adverse price movement between the trades. The buy-write therefore eliminates execution risk.
 
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?
c) 50%
By purchasing the stock for $50 and selling the one-month $50 call for $2, your cost basis is $48. If you are assigned, you will receive $50 per share, which means your simple return is $2/$48 = 4.17%. To annualize this figure, we must realize there are 12 one-month periods in a year so we’d multiply 4.2% * 12 = 0.50, or 50% annualized return. This just shows us that if we were able to continue this performance for one year we’d have a 50% return (not counting the compounding of returns).
 
20) What is the rationale for the covered call strategy?
d) To make more consistent returns and allow compounding to work for you
Covered call writers are trying to capture the more probable returns more often. This allows for more consistent returns and thus allows compounding to take effect.

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