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Question 1 of 10
1. Question
Which of the following is/are the features of an option?
I. An option buyer theoretically has limited profit potential.
II. Options are standardized and can be sold in the marketplace.
III. An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a
specified price on or before a specific date in the future.
IV. The cost of an option is called the premium. The premium is a one-time cost and represents the maximum exposure that the buyer has.
Correct
An options primer
What is an option? An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a specified price on or before a specific date in the future. Options are often compared to insurance. When you buy homeowner’s
insurance, for example, you pay a premium for certain rights. These rights are yours, but the policy can limit the payoff. To some extent, this analogy works for a hedger, but there are major differences when speculating. For example, an option buyer theoretically has unlimited profit potential. Insurance policies have a stated limit. Insurance is not transferable between parties and is usually specific to a person or property. Options are standardized and can be sold in the marketplace. Actually, Exchange-traded options are quite simple.
Incorrect
An options primer
What is an option? An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a specified price on or before a specific date in the future. Options are often compared to insurance. When you buy homeowner’s
insurance, for example, you pay a premium for certain rights. These rights are yours, but the policy can limit the payoff. To some extent, this analogy works for a hedger, but there are major differences when speculating. For example, an option buyer theoretically has unlimited profit potential. Insurance policies have a stated limit. Insurance is not transferable between parties and is usually specific to a person or property. Options are standardized and can be sold in the marketplace. Actually, Exchange-traded options are quite simple.
Question 2 of 10
2. Question
Which of the following is/are the advantages and disadvantages of options?
I. For option buyers, the primary advantage is the unlimited-risk feature.
II. Unlike with futures, with options, the most we can ever lose as a buyer (not as a seller) is what we pay for the option.
III. We could lose less by selling out prior to expiration, and we can even make significant profit trading options, but you have a specifically defined and maximum risk.
IV. The primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price.
Correct
Advantages and disadvantages of options
For option buyers, the primary advantage is definitely the limited-risk feature. Unlike with futures, with options, the most you can ever lose as a buyer (not as a seller) is what you pay for the option. You could lose less by selling out prior to expiration, and you could even make a significant profit trading options, but you have a specifically defined and maximum risk. Additional margin calls are not a possibility, and you can avoid sleepless nights because you know the worst-case scenario the day you initiate an option purchase. The same is not true with futures.
For option buyers, the primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price…or else you lose. When buying options, you can be correct in your market assessment, but if the market doesn’t move far enough in your favor, you still lose.
Consider this: If you buy a wheat option good for the current market price for a premium cost of $1,000, and the market goes nowhere (it stays at the same price for the life of the option), you’re out $1,000 plus fees. The market moved nowhere, and whoever sold that option to you keeps your $1,000.
To profit, the option seller only needs a stagnant market, a move in his direction, or an adverse move that does not cover the premium in full. If you buy a futures contract and hold it for the same time period in a market that goes nowhere, you’re out nothing except the commission costs. In this case, the “limited-risk” option is definitely more costly than the “higher-risk” futures contract. Of course, in this simple example, we don’t know what transpired in the interim period. The market could have sold off wildly, resulting in a margin
call or a stop loss being hit in the future and subsequently recovered. The futures trader could have been knocked out, perhaps more than once, while the options trader (not subject to margin calls) could sit it out. You see, there are no easy answers here, and we’ve only scratched the surface.
Incorrect
Advantages and disadvantages of options
For option buyers, the primary advantage is definitely the limited-risk feature. Unlike with futures, with options, the most you can ever lose as a buyer (not as a seller) is what you pay for the option. You could lose less by selling out prior to expiration, and you could even make a significant profit trading options, but you have a specifically defined and maximum risk. Additional margin calls are not a possibility, and you can avoid sleepless nights because you know the worst-case scenario the day you initiate an option purchase. The same is not true with futures.
For option buyers, the primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price…or else you lose. When buying options, you can be correct in your market assessment, but if the market doesn’t move far enough in your favor, you still lose.
Consider this: If you buy a wheat option good for the current market price for a premium cost of $1,000, and the market goes nowhere (it stays at the same price for the life of the option), you’re out $1,000 plus fees. The market moved nowhere, and whoever sold that option to you keeps your $1,000.
To profit, the option seller only needs a stagnant market, a move in his direction, or an adverse move that does not cover the premium in full. If you buy a futures contract and hold it for the same time period in a market that goes nowhere, you’re out nothing except the commission costs. In this case, the “limited-risk” option is definitely more costly than the “higher-risk” futures contract. Of course, in this simple example, we don’t know what transpired in the interim period. The market could have sold off wildly, resulting in a margin
call or a stop loss being hit in the future and subsequently recovered. The futures trader could have been knocked out, perhaps more than once, while the options trader (not subject to margin calls) could sit it out. You see, there are no easy answers here, and we’ve only scratched the surface.
Question 3 of 10
3. Question
When would a trader not in the options market consider selling options?
I. Call options are primarily sold by bullish traders. Call options are also sold by traders who expect a market to go nowhere over the specified time period.
II. Call options are sold, at times, by bearish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
III. Put options are primarily sold by bearish traders, if the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty.
IV. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts.
Correct
When would a trader not in the options market consider selling options?
• Call options are primarily sold by bearish traders: Call options are also sold by traders who expect a market to go nowhere over the specified time period. Call options are also sold, at times, by bullish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
• Put options are primarily sold by bullish traders: If the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts.
Incorrect
When would a trader not in the options market consider selling options?
• Call options are primarily sold by bearish traders: Call options are also sold by traders who expect a market to go nowhere over the specified time period. Call options are also sold, at times, by bullish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
• Put options are primarily sold by bullish traders: If the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts.
Question 4 of 10
4. Question
What is/are the advantages and disadvantages of selling options?
I. The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately.
II. All he needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received.
III. There is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to buy them.
IV. The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined.
Correct
Advantages and disadvantages of selling options
The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately. All she needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received. In other words, there is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to sell them.
The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options: Because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined. You can think of it like a Las Vegas casino, with the option seller as the house. You know the house has the advantage, but this doesn’t mean any individual on any particular evening couldn’t make a major hit against the house.
Incorrect
Advantages and disadvantages of selling options
The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately. All she needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received. In other words, there is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to sell them.
The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options: Because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined. You can think of it like a Las Vegas casino, with the option seller as the house. You know the house has the advantage, but this doesn’t mean any individual on any particular evening couldn’t make a major hit against the house.
Question 5 of 10
5. Question
How does the time decay affect the options?
I. The time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration).
II. The rate of this increase becomes more rapid as the option gets closer to expiration. This is termed normal time decay.
III. The normal time decay works to the detriment of the seller and the benefit of the buyer.
IV. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the option can only be worth something or, alternatively, nothing—and that’s it.
Correct
Time decay
All else being equal, the time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration). The rate of this decrease becomes more rapid as the option gets closer to expiration. This is termed the normal time decay, and it works to the detriment of the buyer and the benefit of the seller. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the
option can only be worth something or, alternatively, nothing—and that’s it.
Remember, you might buy a call because you think a particular commodity will increase in price, but you could show a loss even if you are correct. This happens when the extent of the rise is insufficient to compensate for the time it takes to occur.
Incorrect
Time decay
All else being equal, the time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration). The rate of this decrease becomes more rapid as the option gets closer to expiration. This is termed the normal time decay, and it works to the detriment of the buyer and the benefit of the seller. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the
option can only be worth something or, alternatively, nothing—and that’s it.
Remember, you might buy a call because you think a particular commodity will increase in price, but you could show a loss even if you are correct. This happens when the extent of the rise is insufficient to compensate for the time it takes to occur.
Question 6 of 10
6. Question
How does volatility affect the type of options?
I. On a percentage basis, volatility affects in-and at-of-the-money options to a greater extent than out-the-money options.
II. In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value.
III. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%.
IV. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
Correct
One last point about volatility: On a percentage basis, volatility affects at-and out-of-the-money options to a greater extent than in-the-money options. Here’s the reason: In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
Incorrect
One last point about volatility: On a percentage basis, volatility affects at-and out-of-the-money options to a greater extent than in-the-money options. Here’s the reason: In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
Question 7 of 10
7. Question
Why does the option sellers take the risk of exercise and the unlimited potential risk?
I. The option seller has a head start; she receives the premium.
II. Receiving premium insulates her risk to some extent, and she makes money in less situations than the buyer.
III. The seller can make money if there is a move favorable to her position (up to when selling puts or down when selling calls).
IV. The seller also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a larger degree than the premium received.
Correct
The risk of exercise and the unlimited potential risk are the risks all option sellers must, by contract, accept. So, why take these risks? The reason is the option seller has a head start; she receives the premium. This insulates her risk to some extent, and she makes money in more situations than the buyer. The buyer needs a move in his favor. If he holds the option until expiration to realize a profit, the buyer needs not only a favorable move but also a move that exceeds the premium he paid. The seller can make money if there is a move favorable to
her position (up to when selling puts or down when selling calls). She also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a lesser degree than the premium received.
Incorrect
The risk of exercise and the unlimited potential risk are the risks all option sellers must, by contract, accept. So, why take these risks? The reason is the option seller has a head start; she receives the premium. This insulates her risk to some extent, and she makes money in more situations than the buyer. The buyer needs a move in his favor. If he holds the option until expiration to realize a profit, the buyer needs not only a favorable move but also a move that exceeds the premium he paid. The seller can make money if there is a move favorable to
her position (up to when selling puts or down when selling calls). She also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a lesser degree than the premium received.
Question 8 of 10
8. Question
Which of the following statements is/are true for Stock index options?
I. A trader who is bearish buys S&P 500 (or any of the other) stock index call options. A bull would, buy the puts.
II. When the premiums are low, a sale might be warranted.
III. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection.
IV. If prices rise by expiration, the purchase price and commissions are gained, and additional funds are required. This is a hedge. If you lose on the put, your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option.
Correct
Stock index options
How many times have you been right about the direction of the stock market, but your stocks went nowhere? Well, you guessed it, there’s a simple way to gamble on the stock market without having to be a stock picker. A trader who is bullish can buy S&P 500 (or any of the other) stock index call options. A bear would, of course, buy the puts. Or, when the premiums are high, a sale might be warranted. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection. They allow the buyer to sell the S&P 500 Index (the 500 biggest stocks, representing more than 80% of the U.S. market) at today’s market price. If prices rise by expiration, the purchase price and commissions are lost, but no additional funds are required. This is a hedge, however, and if you lose on the put, hopefully your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than
the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option. Why wouldn’t a bear just sell his stocks? For long-term investors wary of a market dip, this is cheaper and easier. Selling a large portfolio of stocks would involve numerous and costly commissions. The commission on each S&P option generally is cheaper. Plus, you need not forgo dividend income on your stocks or worry about long-term capital gains taxes, and, if your stocks outperform the market in general, you have a relationship
gain. If the market declines, the investor/hedger can sell his put at a profit and hold onto the stocks. If the market rises, the stocks will be worth more, and the put has to be considered insurance that just never needed to be used.
Incorrect
Stock index options
How many times have you been right about the direction of the stock market, but your stocks went nowhere? Well, you guessed it, there’s a simple way to gamble on the stock market without having to be a stock picker. A trader who is bullish can buy S&P 500 (or any of the other) stock index call options. A bear would, of course, buy the puts. Or, when the premiums are high, a sale might be warranted. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection. They allow the buyer to sell the S&P 500 Index (the 500 biggest stocks, representing more than 80% of the U.S. market) at today’s market price. If prices rise by expiration, the purchase price and commissions are lost, but no additional funds are required. This is a hedge, however, and if you lose on the put, hopefully your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than
the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option. Why wouldn’t a bear just sell his stocks? For long-term investors wary of a market dip, this is cheaper and easier. Selling a large portfolio of stocks would involve numerous and costly commissions. The commission on each S&P option generally is cheaper. Plus, you need not forgo dividend income on your stocks or worry about long-term capital gains taxes, and, if your stocks outperform the market in general, you have a relationship
gain. If the market declines, the investor/hedger can sell his put at a profit and hold onto the stocks. If the market rises, the stocks will be worth more, and the put has to be considered insurance that just never needed to be used.
Question 9 of 10
9. Question
Which of the following statements is/are true for buying options to protect futures?
I. Buying options to protect futures involves buying a call with a long future.
II. Buying options to protect futures involves buying a put with short futures.
III. Creating synthetic options means a put combined with a long future is similar to a call.
IV. Creating synthetic options means a call in conjunction with the short futures is similar to a put.
Correct
Buying options to protect futures
Buying options to protect futures involves buying a put with long futures or buying a call with short futures. This strategy is also known as creating synthetic options because a put combined with long futures is similar to a call, and the call in conjunction with the short futures is similar to a put. You can make a case that if you buy an at-the-money call option while simultaneously holding a short futures position (synthetic put), or you buy a put option while simultaneously holding a long futures position (synthetic call) that the overall position will act just like a put or a call (so why bother?). Because this can be a better strategy since it gives you added flexibility.
Incorrect
Buying options to protect futures
Buying options to protect futures involves buying a put with long futures or buying a call with short futures. This strategy is also known as creating synthetic options because a put combined with long futures is similar to a call, and the call in conjunction with the short futures is similar to a put. You can make a case that if you buy an at-the-money call option while simultaneously holding a short futures position (synthetic put), or you buy a put option while simultaneously holding a long futures position (synthetic call) that the overall position will act just like a put or a call (so why bother?). Because this can be a better strategy since it gives you added flexibility.
Question 10 of 10
10. Question
Why professionals sell options generally to the public?
I. The professionals hedge the sales of options with a ratio of long futures, but the public generally likes to purchase premium.
II. The advantage of selling options is that you can capitalize on the time decay of options.
III. The premiums the people pay for options eventually rise to option heaven, the option seller looses these premiums.
IV. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures.
Correct
Covered option writing
As we’ve discussed, the advantage and attraction of buying options are that your risk is limited and predetermined, and the profit potential is unlimited. However, the majority of options expire worthless, and the premiums eventually disappear. Therefore, buying options is generally a losing proposition. This is not to say that you cannot make good money in a major bull or major bear market, but be advised that professionals primarily sell options (generally to the public). They might hedge these sales with a ratio of long or short futures, but the public generally likes to purchase premium. The advantage of selling options is that you can capitalize on the time decay of options. Because the premiums that people pay for options eventually rise to option heaven, the option seller gains these premiums. While writing options is generally a winning strategy, the big disadvantage is that the risk is unlimited, while the profit potential is limited to
the premiums received. When option premiums are high, the general rule of thumb is that it is better to sell options than to buy them.
The advantage of futures is the unlimited profit potential, but the risk is theoretically unlimited also. You should, therefore, use risk-management techniques (stops). Stops are not foolproof, but they generally work efficiently.
The main problem with stops are that they can be filled away from your intended risk level at times and in a volatile market you can be stopped out only to have the market eventually go back your way. On the other hand, if you do not have stops, you cannot predetermine what your risk is. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures. For example, in a recent bull soybean market, I bought the November beans at $18.00 and sold the 1800 calls for 60¢. This gave me 60¢
in downside protection. At expiration, if the market was anywhere above $17.40, I would still profit from this trade. If the market was anywhere above $18/bushel at expiration, I would keep the 60¢, or $3,000 gross per covered contract position —not a bad profit.
Incorrect
Covered option writing
As we’ve discussed, the advantage and attraction of buying options are that your risk is limited and predetermined, and the profit potential is unlimited. However, the majority of options expire worthless, and the premiums eventually disappear. Therefore, buying options is generally a losing proposition. This is not to say that you cannot make good money in a major bull or major bear market, but be advised that professionals primarily sell options (generally to the public). They might hedge these sales with a ratio of long or short futures, but the public generally likes to purchase premium. The advantage of selling options is that you can capitalize on the time decay of options. Because the premiums that people pay for options eventually rise to option heaven, the option seller gains these premiums. While writing options is generally a winning strategy, the big disadvantage is that the risk is unlimited, while the profit potential is limited to
the premiums received. When option premiums are high, the general rule of thumb is that it is better to sell options than to buy them.
The advantage of futures is the unlimited profit potential, but the risk is theoretically unlimited also. You should, therefore, use risk-management techniques (stops). Stops are not foolproof, but they generally work efficiently.
The main problem with stops are that they can be filled away from your intended risk level at times and in a volatile market you can be stopped out only to have the market eventually go back your way. On the other hand, if you do not have stops, you cannot predetermine what your risk is. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures. For example, in a recent bull soybean market, I bought the November beans at $18.00 and sold the 1800 calls for 60¢. This gave me 60¢
in downside protection. At expiration, if the market was anywhere above $17.40, I would still profit from this trade. If the market was anywhere above $18/bushel at expiration, I would keep the 60¢, or $3,000 gross per covered contract position —not a bad profit.
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