Options Trading and Hedging Quiz

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Questions and Answers

Which term describes an option that has intrinsic value?

Naked call

In-the-money (correct)

At-the-money

Cash-secured put write

What is the term for the official price at which an option is offered to potential buyers?

Market price

Strike price

Subscription price

Offering price (correct)

Which term refers to the right to sell an underlying asset at a predetermined exercise price?

Put option (correct)

Covered call

Call option

Warrant

Which of the following describes a contract that obligates the buyer to purchase an asset at a future date?

Futures contract Signup and view all the answers

Which of these terms refers to the difference between the exercise price and the market price of an option?

Intrinsic value Signup and view all the answers

Which term describes the risk that a counterparty will not fulfill their financial obligations in a derivatives contract?

Default risk Signup and view all the answers

What does 'open interest' refer to in derivatives trading?

The total number of outstanding option contracts Signup and view all the answers

What is a call option that is not covered by underlying assets known as?

Naked call Signup and view all the answers

Which term is typically associated with the trading of commodities and refers to a legally binding agreement to buy or sell?

Futures contract Signup and view all the answers

What is the maximum loss that a naked put writer may face?

The price of the underlying stock can fall to a price no lower than $0. Signup and view all the answers

How is the premium received by a put writer determined when options are in-the-money?

It consists of both intrinsic value and time value. Signup and view all the answers

What is the effective price for buying the stock using a cash-secured put write?

The strike price minus the premium received. Signup and view all the answers

In the context of naked put writing, what factor could allow a put writer to still profit despite being assigned?

The amount of premium received could offset losses. Signup and view all the answers

What is a common feature of all derivatives?

They involve contractual agreements between two parties. Signup and view all the answers

Which of the following statements is true regarding the risks associated with a naked call writer compared to a naked put writer?

Naked put writing is less risky than naked call writing. Signup and view all the answers

What is the maximum theoretical loss for a naked call writer?

Theoretically unlimited Signup and view all the answers

When writing five XYZ December 55 put options, what amount does the put writer need to set aside to cover the purchase obligation?

$27,500 Signup and view all the answers

What typically happens to a derivative contract after its expiration date?

It is automatically terminated. Signup and view all the answers

In the context of forward contracts, what is usually not required?

An up-front payment. Signup and view all the answers

In a covered call strategy, what does the effective sale price equal when the stock price exceeds the strike price?

$54.55 Signup and view all the answers

What does the premium paid by the buyer in an options contract confer?

The right to buy or sell the asset at a preset price. Signup and view all the answers

What components make up the $4.55 premium received by the covered call writer?

Both intrinsic value and time value Signup and view all the answers

At what stock price does the covered call writer start to incur a loss on the underlying shares purchased at $40?

$54.55 Signup and view all the answers

What unique characteristic distinguishes derivatives from traditional financial assets like stocks?

Derivatives are considered a zero-sum game. Signup and view all the answers

How many shares does the investor own when executing the covered call strategy as described?

1,000 shares Signup and view all the answers

Which of the following is true regarding the relationship between buyers and sellers of derivatives?

Buyers seek to purchase derivatives for the lowest price. Signup and view all the answers

If the underlying stock price remains below the strike price of $50 at expiration, what happens to the written call options?

They expire worthless Signup and view all the answers

What is a common obligation of both parties in a derivative agreement?

To fulfill their obligations on or before the expiration date. Signup and view all the answers

What is the intrinsic value of the option as stated in the covered call strategy example?

$2.50 Signup and view all the answers

What does the term 'counterparts' refer to in the context of derivatives?

The two parties involved in the agreement. Signup and view all the answers

When written call options are in-the-money, what obligation does the covered call writer have?

To sell shares at the strike price to the buyer Signup and view all the answers

Why might a good faith deposit be used in a forward transaction?

To provide assurance that the terms will be honored. Signup and view all the answers

What profit does the investor realize per share from the covered call position?

$14.55 Signup and view all the answers

What is a significant requirement of options compared to forward contracts?

They involve an upfront premium from the buyer. Signup and view all the answers

What is the primary function of derivative dealers in the OTC markets?

To take the other side of positions entered into by end users Signup and view all the answers

Which of the following correctly defines a call option?

It gives the holder the right to buy the underlying asset Signup and view all the answers

Why might hedging not always be the optimal choice for a trader?

Hedging can be complex and not result in a net gain Signup and view all the answers

What obligation does the seller of a put option have?

To buy the underlying asset at a specified time Signup and view all the answers

Which of the following best describes the roles of market makers in exchange-traded markets?

They act as intermediaries by offering to buy and sell contracts Signup and view all the answers

What is a significant risk associated with the decision to hedge?

It might lead to higher transaction costs and capital requirements Signup and view all the answers

What is the typical structure of an option contract?

A mutual agreement between two parties with specified rights and obligations Signup and view all the answers

What type of dealers are primarily involved in the Canadian OTC derivatives market?

Chartered banks and their investment dealer subsidiaries Signup and view all the answers

What is one of the key characteristics that differentiates options from other financial instruments?

An option gives the holder discretionary rights without obligations Signup and view all the answers

What limitation is often faced by individuals considering hedging their investments?

A lack of understanding of hedging strategies Signup and view all the answers

Study Notes

Introduction to Derivatives

Derivatives are contractual agreements between two parties (buyers and sellers).
They specify rights and obligations, including a set price and expiration date.
Upon expiration, contracts are automatically terminated if not executed.

Characteristics of Derivatives

Each contract includes a pricing formula for future transactions.
Forwards don't require upfront payments; performance bonds may enhance trust.
Options require payment (premium) for the right to buy or sell assets.
Derivatives operate as a zero-sum game; gains for one party equal losses for the other.
Hedging strategies are complex and may not eliminate all risks.

Role of Derivative Dealers

Market makers facilitate trading in exchange-traded markets by readying contracts for buying or selling.
Key participants include banks, investment dealers, and professional individuals.
In the OTC market, chartered banks and subsidiaries are primary derivative dealers.

Types of Options

Options involve a contract between a long position (buyer) and a short position (seller).
Call options give the holder the right to buy the underlying asset; put options allow selling rights.
Writers of naked calls face theoretically unlimited losses as there's no cap on asset price increases.

Covered Call Strategy Example

An investor purchases 1,000 shares at $40 and writes 10 call options at $4.55 each, accumulating a premium of $4,550.
The options are classified as in-the-money, with intrinsic value of $2.50 and time value of $2.05.
If exercised, the effective sale price adjusts to $54.55, leading to a total profit of $14.55 per share.

Cash-Secured Put Writing Example

An investor writes five put options at a strike price of $55, receiving a premium of $4.85 each (totaling $2,425).
The intrinsic value is $2.50, and the time value is $2.35, with cash reserved for potential asset purchase ($27,500).
This strategy allows investors to potentially acquire stock at an effective discount when combined with the premium.

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Description

Test your knowledge on American-style options, hedging strategies, and important concepts in options trading. This quiz covers key terms like intrinsic value and arbitrage, helping you understand how to navigate the options market effectively.