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?

    <p>Futures contract</p> 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?

    <p>Intrinsic value</p> Signup and view all the answers

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

    <p>Default risk</p> Signup and view all the answers

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

    <p>The total number of outstanding option contracts</p> Signup and view all the answers

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

    <p>Naked call</p> 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?

    <p>Futures contract</p> Signup and view all the answers

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

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

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

    <p>It consists of both intrinsic value and time value.</p> Signup and view all the answers

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

    <p>The strike price minus the premium received.</p> 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?

    <p>The amount of premium received could offset losses.</p> Signup and view all the answers

    What is a common feature of all derivatives?

    <p>They involve contractual agreements between two parties.</p> 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?

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

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

    <p>Theoretically unlimited</p> 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?

    <p>$27,500</p> Signup and view all the answers

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

    <p>It is automatically terminated.</p> Signup and view all the answers

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

    <p>An up-front payment.</p> 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?

    <p>$54.55</p> Signup and view all the answers

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

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

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

    <p>Both intrinsic value and time value</p> 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?

    <p>$54.55</p> Signup and view all the answers

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

    <p>Derivatives are considered a zero-sum game.</p> Signup and view all the answers

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

    <p>1,000 shares</p> Signup and view all the answers

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

    <p>Buyers seek to purchase derivatives for the lowest price.</p> 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?

    <p>They expire worthless</p> Signup and view all the answers

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

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

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

    <p>$2.50</p> Signup and view all the answers

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

    <p>The two parties involved in the agreement.</p> Signup and view all the answers

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

    <p>To sell shares at the strike price to the buyer</p> Signup and view all the answers

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

    <p>To provide assurance that the terms will be honored.</p> Signup and view all the answers

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

    <p>$14.55</p> Signup and view all the answers

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

    <p>They involve an upfront premium from the buyer.</p> Signup and view all the answers

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

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

    Which of the following correctly defines a call option?

    <p>It gives the holder the right to buy the underlying asset</p> Signup and view all the answers

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

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

    What obligation does the seller of a put option have?

    <p>To buy the underlying asset at a specified time</p> Signup and view all the answers

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

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

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

    <p>It might lead to higher transaction costs and capital requirements</p> Signup and view all the answers

    What is the typical structure of an option contract?

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

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

    <p>Chartered banks and their investment dealer subsidiaries</p> Signup and view all the answers

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

    <p>An option gives the holder discretionary rights without obligations</p> Signup and view all the answers

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

    <p>A lack of understanding of hedging strategies</p> 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.

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