CHAPTER 5 – PROBLEM SETS DISCUSSION PROBLEMS

CHAPTER 5 – PROBLEM SETS DISCUSSION PROBLEMS: 1. Is selling a naked put the same as a limit buy order if the strike of the option is the same as the limit order? Why or why not? 2. Why are options often compared to insurance? 3. One of the important price attributes of options is time left until expiry. Based on this fact, why do longer-term options have a higher price than shorter-term options, ceteris paribus? 4. Why does a naked call offer potentially unlimited risk, but a naked put doesn’t? 5. Why would a broker insist on more investor experience before allowing the client access to more complex strategies? ADDITIONAL PROBLEMS: 1. An equity has a price of $21.57 per share, and Mr. Smith sold to open a 20-strike put for $1.05. If the put is exercised, what happens? a. Nothing, because the put has no value. b. Mr. Smith sells the equity at $20 per share and gains $1.05 of option premium; Mr. Smith receives $2,001.05. c. Mr. Smith buys the stock at $20 per share and receives $1.05 of option premium; Mr. Smith pays $1,998.95. d. Mr. Smith buys the stock at $20 per share and receives $1.05 per share of option premium; Mr. Smith pays a net amount of $1,895 for the stock. 2. You have purchased a 45-strike call option for $4.35 which expires in 35 days and the stock is currently at $43.69 per share. At expiry, the stock closes at $46.05. What is your total profit or loss? a. A net loss of $330. b. Neither a gain or a loss. c. A net gain of $435. d. A net loss of $435. e. A net gain of $330. 3. You sold a 22.5 strike put for $1.65 on a stock that currently sells for $24.98. If the put is exercised, what is the net price of the stock, and who buys it? a. You buy it at $22.50 a share. b. The counterparty buys it for a net price of $22.50 a share. c. The counterparty buys it for $24.15. d. You buy it for a net price of $24.15 per share. e. You buy it for a net of $20.85 per share. 4. You have purchased a 17.5 strike put for $1.57 which expires in 48 days and the stock is currently at $18.05 per share. At expiry, the stock closes at $16.87. What is your total profit or loss? a. A net gain of $157. b. c. d. e. A net gain of $63. A net loss of $63. A net gain of $94. A net loss of $94. 5. You sold-to-open ten 25-strike calls for $2.10 each on a stock you own. You own 1,200 shares of that stock, which was purchased at $23.66 per share. The stock rises to $$25.41 and 1,000 shares are called at $25, while the rest are sold at $25.41. What is your total return? (Ignore taxes and transaction costs). 6. You own a call option and the underlying just paid a dividend of $.25 per share. What affect does it have on the price of the option? a. The option decreases $0.25 in value. b. The option decreases $25.00 in value. c. The option increases in value by $25.00 d. The option increases in value by $0.25 7. Opening a position means a. Buying a contract b. Selling a contract c. Either buying or selling contracts which may reduce or increase account exposure d. Exercising a call contract 8. Mr. Kuhn purchases an out-of-the-money call option for $275.00 with a 55-strike. The underlying stock traded at $52.35 at the time the option was purchased. The stock drops to $50.13 by expiry. Mr. Kuhn: a. Loses his entire investment in the option plus an additional loss of $222 in stock value. b. Loses his entire investment in the option only, -$275. c. Neither gains nor loses. d. Gains $275 in premium. 9. Ms. Spencer sells-to-open an at-the-money 105-strike call for $1,045. The underlying stock rises to $136.95 per share at expiry. Ms. Spencer: a. Gains $1,045 in premium after option expiry. b. Loses $1,045 in premium plus $3,195 in capital losses. c. Gains $1,045 in premium plus $3,195 in capital gains. d. Gains $1,045 in premiums and loses $3,195 in capital losses for net loss of $2,150. 10. Ms. Spencer sells-to-open a 10-strike out-of-the-money put for $115. The underlying is a biotech trading at $11.25 per share. What happens if the stock drops to $9.99 per share at expiry? a. Mr. Spencer keeps the premium of $115. b. Mr. Spencer keeps the premium of $115 and he buys the underlying at $10.00 per share. c. Mr. Spencer sells the underlying at $10.00 per share and keeps the premium. d. Mr. Spencer must close the short put at market before expiry. 11. Mr. Johnson buys-to-open a 300-strike SPY put for $786, based on his bearish outlook. SPY closes at 294.63 at expiry. What is Mr. Johnson’s overall profit or loss? 12. Ms. Johnson buys a 55-strike call for $580 for an underlying priced at $54.34. If the underlying price rises to $55.65, what is Ms. Johnson’s overall profit or loss? 13. You want to sell-to-open 10 “naked” 135-strike IBM puts. If you are approved for this level of trading, can you do this? a. Yes. With broker approval of Level III trading, you can do so. b. Yes, if you have enough margin power to buy 10 shares of IBM at the market price posted at the close of trading on the day of option expiry. c. No. Naked put writing is not permitted under any circumstances. d. Yes, if you have enough margin to buy 1000 shares of IBM at $135 per share. e. Yes, if you have enough margin to buy 1000 shares of IBM at the market price posted at the close of trading on the day of option expiry. 14. You sell-to-open 10 “naked” 12.50-strike calls for a stock quoted at $11.25. The next week, the underlying company is being offered $20 per share in a hostile bid and your options are exercised. What happens to your account? a. It is closed by the broker and you are sanctioned. b. You must deliver the shares in your account. c. You must buy shares in the open market and deliver the shares to the holder of the option, absorbing losses, and bringing in sufficient capital to even out the account to at least zero. d. You must recapitalize first, and then buy the shares in the open market and deliver the shares to the option holder. 15. You own 5 150-strike options for a stock trading at $157.36 per share when it announces a 2:1 split. Six months later, the same stock splits again, 3:2. How many options do you now own, and what is its strike price?

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