the  main  difference  between  American-style  options  and
European-style options?Answer: The only difference between American and European optionsis when they can be exercised.Discussion: American-style options can be exercised at any time onor before their expiration dates. European options can be exercisedonly on (not before) their expiration dates. While stock options andexchange-traded  funds  settle  American-style,  most  index  optionshave the European-style settlement feature.
13. What are the three possible resolutions of an options contract?
Answer: The options contract may expire and become worthless, beexercised by its owner, or be assigned.Discussion: If an out-of-the-money option is not exercised beforeexpiration, it will become worthless. If the option is in-the-moneyat expiration, it will be exercised and the option seller will be facedwith assignment of that option. For example, if the price of the un-derlying  stock  rises  above  a  short  call  strike  price  before  expira-tion, the short option will either be exercised or be assigned to anoption buyer. The call option seller is then obligated to deliver 100shares of the underlying stock to the option buyer at the short callstrike price. This entails buying the underlying stock at the higher(market)  price  and  delivering  it  to  the  option  buyer  at  the  lower(strike) price. The difference between these two prices constitutesthe seller’s loss and the buyer’s open position proﬁt. This can be ahuge loss in fast markets, which is why we never recommend sell-ing naked options.
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If the writer of an option receives ______________, the option has beenassigned and the writer is obligated to buy (or sell) the speciﬁed amountof underlying assets at the strike price from (or to) the assigned holder.Answer: C—An exercise notice.Discussion: Assignment will occur if the option is in-the-money nearexpiration. If so, the Options Clearing Corporation sends an exercisenotice  to  a  brokerage  ﬁrm  and  the  brokerage  ﬁrm  then  delivers  thenotice to the option writer.
15. A  stock  option  represents  the  right  to  buy  or  sell  ______________
shares of the underlying stock.Answer: B—100.Discussion: Stock options are standardized to represent 100 sharesof the underlying stock. Futures, in contrast, vary depending on thecommodity’s characteristics.
16. The stock option expiration date is always the Saturday following the
______________ Friday of the expiration month.Answer: C—Third.Discussion: Stock  options  expire  at  close  of  business  prior  to  theSaturday after the third Friday of the expiration month. The last dayto trade them is therefore on the third Friday of the option’s expira-tion month.
17. Strike prices for stock options come in increments of ______________
for stocks over $25 per share.Answer: C—$5.Discussion: In most cases, stocks with market prices of $25 or morewill have strike prices spaced at 5-point increments.
18. True  or  False:  The  strike  prices  and  expiration  dates  of  optionscontracts  differ  depending  on  the  underlying  instrument  they represent.Answer: True.Discussion: Different  underlying  assets  (stocks,  indexes,  futures,etc.)  have  different  speciﬁcations  for  their  respective  options  con-tracts. To ﬁnd the current information regarding a contract, check theweb site of the exchange where the contract is listed for trading, orgo to www.optionetics.com and enter the stock symbol, then click onOption Chain.
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19. Name the ﬁve components that make up option symbols.
Answer: Underlying  ﬁnancial  instrument,  root  symbol,  expirationmonth, strike price, option type.Discussion: Each  options  contract  can  be  described  using  threefactors.  The  ﬁrst  is  the  root  symbol.  Sometimes  the  root  symboland the underlying ﬁnancial instrument are the same; for instance,IBM is the root symbol for International Business Machines (IBM).Microsoft  is  an  example  of  a  stock  with  a  root  symbol  that  is  notthe same as the stock. The stock symbol is MSFT, while the optionsymbol is MSQ. The second part of an option symbol tells the expi-ration and reﬂects whether the option is a put or a call (A through Lfor calls and M through X for puts). If the expiration month is Janu-ary and the option is a call, the second part of the symbol is an A; ifthe contract is a February put, the second part of the symbol is anN. Finally, the last part of the option symbol is the strike price. Theletter A is used for a strike price of 5, B for 10, C for 15, all the wayup to T for 100. Therefore, the symbol for the IBM February 75 callis IBMBO.
20. Name the two types of options.
Answer: Calls and puts.Discussion: Calls are options that give the buyer the right to buyan underlying asset. Puts give the buyer the right to sell the under-lying asset.
21. A ______________ gives the buyer the right (not the obligation) to buy
the underlying stock shares or futures contract.Answer: A—Call option.Discussion: If  you  exercise  this  type  of  option,  you  are  calling  theunderlying  security  away  from  the  option  seller.  Hence,  the  optionseller is obligated to deliver 100 shares of the underlying stock to theoption holder.
22.
If the market price is more than your strike price, your call option is______________.Answer: B—In-the-money.Discussion: If the strike price is below the market price, the optionscontract has intrinsic value because it enables the owner to purchasethe underlying asset at the lower strike price. So, it is in-the-money.
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23.
24.
25.
26.
27.
28.
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If the market price is less than your strike price, your call option is______________.Answer: C—Out-of-the-money.Discussion: A  call  option  that  has  a  strike  price  above  the  marketprice has no intrinsic value and is therefore out-of-the-money.
If  the  market  price  is  the  same  as  your  strike  price,  your  option  is______________.Answer: A—At-the-moneyDiscussion: When the strike price is equal to the price of the under-lying asset, whether puts or calls, the contract is at-the-money.
If you buy call options, you are ______________.Answer: A—Going long.Discussion: Anytime you buy an options contract, you are going long—even if it is a put option going long a call option is a bullish strategy.
If you sell call options, you are ______________.Answer: B—Going short.Discussion: Option  sellers  are  said  to  be  short  the  options  contract.Going short a call option is a bearish strategy and comes with unlimitedrisk, which is why we never recommend selling naked options.
If  you  are  ______________  (believe  the  market  will  rise),  then  youwant to buy calls.Answer: B—Bullish.Discussion: Buying  a  call  is  a  bullish  strategy  because  it  allows  atrader to proﬁt from a rise in the price of the underlying asset. A longcall can also be used to predetermine how much a trader wants to payfor the underlying asset—regardless of how high the price climbs overtime until the option expires. A bull expects the market to move higher.A rising market is called bullish because bulls buck up with their horns.
If  you  are  ______________  (believe  the  market  will  drop),  then  youwant to buy puts.Answer: A—Bearish.Discussion: Buying a put is a bearish strategy because it allows a traderto proﬁt from a decline in the price of the underlying asset. A long putcan also be used to predetermine how much a trader wants to receivefor selling the underlying asset—regardless of how low the price fallsover time until the option expires. Bears expect the underlying asset to
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29.
30.
fall.  A  falling  market  is  called  bearish  because  bears  swat  downwardwith their paws.
If you buy a call option, your risk is ______________.Answer: D—The price of the premium.Discussion: The  total  risk  associated  with  buying  an  option  is  thecost of entering the agreement (the premium).
If you sell a call option, your risk is ______________.Answer: A—Unlimited.Discussion: Call option sellers enter into an obligation to sell the un-derlying  asset  at  a  predetermined  price.  If  they  do  not  already  ownthe underlying asset and it moves higher in price, they will likely befaced with assignment and will be forced to buy the underlying assetto  cover  assignment.  Furthermore,  since  there  is  theoretically  nolimit  to  how  high  an  underlying  asset  might  go,  the  risk  associatedwith selling call options is theoretically unlimited.
31.
If the current price of XYZ is $50, ﬁll in the blanks designating eachstrike as ITM, ATM, or OTM.Answer:
Strike Price of Option
Call Option Moneyness
70
65
60
55
50
45
40
35
30
OTM
OTM
OTM
OTM
ATM
ITM
ITM
ITM
ITM
Discussion: If the strike price is equal to the price of the underlyingasset,  the  option  is  said  to  be  at-the-money.  If  the  strike  price  ishigher  than  the  underlying  asset  price,  the  call  option  is  out-of-the-money. If the strike price is lower than the underlying asset price, thecall option is in-the-money.
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32. Name the two ways proﬁts can be realized from purchasing a call
option.Answer:
1.
2.
If the underlying asset increases in price before the option ex-pires, the holder can purchase the underlying asset at the lowerstrike price.
If  the  underlying  asset’s  price  increases  before  expiration,  thevalue of the option increases and can be sold at a proﬁt.
Discussion: Option  owners  can  either  exercise  the  options  con-tract or close the position by selling the same number of an identi-cal options contract. For instance, if a trader holds 10 IBM January90 calls and IBM rises to $100, the trader can exercise the option,which would allow him or her to buy 1,000 shares of the stock forthe strike price of $90 and then sell those 1,000 shares in the mar-ket for $100. Alternatively, the trader could sell 10 IBM January 90calls  and  close  the  position  at  a  proﬁt  without  exercising  the  op-tions.  In  both  cases,  since  the  stock  has  risen  from  $90  to  $100  ashare, a proﬁt will be realized.
33. All  the  options  that  have  the  same  unit  of  trading,  expiration  date,
and strike price are called an ______________.Answer: B—Option series.Discussion: An option series describes the options on the same un-derlying asset that have the same unit of trading, strike price, andexpiration date.
34. A ______________ gives the buyer the right (not the obligation) to sell
the underlying stock shares or futures contract.Answer: B—Put option.Discussion: When exercising an options contract, the owner of a putwill instruct the brokerage ﬁrm to sell (or put) the underlying asset tothe option writer.
35.
If the market price is less than your strike price, your put option is______________.Answer: B—In-the-money.Discussion: A  put  option  has  intrinsic  value  when  the  price  of  theunderlying asset falls below the strike price of the options contract.In that case, the option is in-the-money because it allows the holderto purchase the underlying asset at the lower strike price if exercised.
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36.
37.
38.
39.
40.
41.
If the market price is more than your strike price, your put option is______________.Answer: C—Out-of-the-money.Discussion: A put option that has a strike price below the price ofthe underlying asset has no intrinsic value. It is out-of-the-money.
If the market price is the same as your strike price, your put option is______________.Answer: A—At-the-money.Discussion: When  the  strike  price  is  equal  to  the  underlying  asset,whether puts or calls, the contract is at-the-money.
If you buy put options, you are ______________.Answer: A—Going long.Discussion: If you buy an option, you are going long that contract.Whether it is a put or a call doesn’t matter. Going long a put option isa bearish strategy.
If you sell put options, you are ______________.Answer: B—Going short.Discussion: Anytime you sell an option, you are going short. Goingshort a put option is a bullish strategy.
If you buy a put option, your risk is ______________.Answer: D—The price of the premium.Discussion: The  total  risk  associated  with  buying  an  option  is  thepremium paid for that option. This is true whether the option is a putor a call.
If you sell a put option, your risk is ______________.Answer: A—Limited to the stock falling to zero.Discussion: The  risk  of  selling  puts  can  be  substantial  if  the  stockfalls sharply and the put writer is assigned the stock. However, unlikenaked call selling, the risk is not unlimited. It is limited due to the factthat the stock price cannot fall below zero.
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If the current price of XYZ is $50, ﬁll in the blanks designating eachstrike as ITM, ATM, or OTM.
Answer:
Strike Price of Option
Put Option Moneyness
70
65
60
55
50
45
40
35
30
ITM
ITM
ITM
ITM
ATM
OTM
OTM
OTM
OTM
Discussion: If the strike price is equal to the price of the underlyingasset,  the  option  is  said  to  be  at-the-money.  If  the  strike  price  ishigher than the underlying asset price, the put option is in-the-money.If the strike price is lower than the underlying asset price, the put isout-of-the-money.
MEDIA ASSIGNMENT
Now  that  we  have  created  an  option  chain,  let’s  make  a  few  observa-tions. First, notice that the premiums of the calls with the same expira-tion  date  but  different  strike  prices  decrease  as  you  move  down  thetable.  Why  is  that?  In  contrast,  the  prices  of  the  puts  increase as  youmove down the table.
Can you identify the at-the-money options? Also, notice that the pre-miums of the options with the same strike price but different expirationdates are different. The option with the shortest amount of time left untilexpiration has the smallest premium. Furthermore, in every case, the bidis  less  than  the  ask  (offer)  price.  Do  you  remember  what  the  differencebetween the bid and ask price is? As you probably recall, this is known asthe bid-ask spread.
Once  you  clearly  understand  an  option  chain,  the  various  elements,
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and why the prices vary among the options contracts, you probably havedeveloped  a  good  understanding  of  the  options  basics.  So,  it’s  time  tomove on to the next chapter and the discussion of basic trading strategies.
VOCABULARY DEFINITIONS
American-style: An  options  contract  that  settles  American-style  canbe  exercised  at  any  time  prior  to  expiration.  Stock  options  settle American-style.Assignment: The receipt of an exercise notice by an option writer thatrequires him or her to sell (in the case of a call) or purchase (in the case ofa put) the underlying security at the speciﬁed strike price.At-the-money: Refers to an option with an exercise or strike price thatis equal, or almost equal, to the current market price of the underlyingsecurity.Automatic exercise: An exercise by the clearing ﬁrm in which the ﬁrmautomatically exercises an in-the-money option at expiration.Credit: Amount  that  is  added  to  the  trading  account  when  an  optionstrader collects a premium for selling options.Debit: The  amount  that  is  subtracted  from  a  trader’s  account  when  atrade involves the net purchase of options contracts.European-style: An option contract that can be exercised only on theexpiration date.Exercise: To implement the right of the holder of an option to buy (in thecase of a call) or sell (in the case of a put) the underlying security. Whenyou exercise an option, you carry out the terms of an option contract.Expiration date: The day when the options contract expires. For stockoptions, the expiration date falls on close of business prior to the Satur-day following the third Friday of the expiration month.In-the-money: Refers to an options contract that has intrinsic value. Acall is in-the-money if the strike price is less than the market price. A putis in-the-money if the strike price is greater than the market price of theunderlying security.Intrinsic value: The amount by which an option is in-the-money. Out-of-the-money options have no intrinsic value. To calculate the intrinsic valueof  a  call  option,  take  the  price  of  the  underlying  and  subtract  the  strikeprice. A put option’s intrinsic value equals the strike price minus the priceof the underlying.
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Long: Buying  an  investment  security.  Traders  will  go  long  when  theyexpect the instrument to increase in value.Moneyness: A  term  to  deﬁne  whether  an  options  contract  is  in-the-money, at-the-money, or out-of-the-money.Near-the-money: Refers  to  an  option  with  a  strike  price  that  is  almostequal to the current market price of the underlying security.Out-of-the-money: Refers  to  an  options  contract  that  has  no  intrinsicvalue; for instance, a call option whose exercise price is above the currentmarket price of the underlying security or futures contract.Root symbol: The ﬁrst part of an options symbol that represents the un-derlying security. For instance, the root symbol for International BusinessMachines is IBM.Series: All option contracts of the same class that also have the same unitof trade, expiration date, and exercise price.Short: Selling  an  investment  security  in  anticipation  that  the  pricewill fall.Strike  price: A  price  at  which  the  stock  or  commodity  underlying  acall or put option can be purchased (call) or sold (put) over the speci-ﬁed period.Symbol: A three-, four-, or ﬁve-letter sequence that denotes a stock, option,or futures contract.
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CHAPTER 4
BasicTradingStrategies
SUMMARY
In addition to risk graphs, Chapter 4 covers the following eight strategies:long stock, short stock, long call, short call, covered call, long put, shortput, and covered put. These are the basic strategies that almost all optionstraders  ﬁrst  learn.  In  fact,  many  options  traders  begin  as  stock  traders.From there, many move on to shorting stocks or long calls. These strate-gies, while simple and widely used, form the basis for many more complextrading strategies, which are covered in detail in later chapters.
Before initiating any options trade, the strategist needs to determinethe trade’s potential risks and rewards. A risk proﬁle can be generated toprovide a graphical representation of the overall risk of a speciﬁc trade. Byvisualizing  the  potential  risk  and  reward,  a  trader  can  ﬁnd  promisingtrades and identify potential pitfalls.
QUESTIONS AND EXERCISES
1. Every  trade  you  place  has  a  corresponding  ______________  thatgraphically  shows  your  potential  risk  and  potential  reward  over  arange of prices and time periods.
A. Risk curve.
B. Risk graph.
C. Risk proﬁle.
D. All of the above.
53
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2. Reading  a  risk  proﬁle  is  pretty  easy.  The  horizontal  numbers  at the  bottom  of  the  chart  read  from  left  to  right  showing  the______________.
A. Market price.
B. Option premium price.C. Proﬁt and loss.
D. Change in overall position delta.
3. The vertical numbers from top to bottom show ______________.
A. Market price.
B. Option premium price.
C. Proﬁt and loss.
D. Change in overall position delta.
4. Label each risk graph with the correct strategy: long stock, long call,
long put, short stock, short call, short put.
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5. The long stock strategy provides ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with unlimited risk.
C. Unlimited proﬁt potential with unlimited risk.
D. Unlimited proﬁt potential with limited risk.
6. A stock does not have premium or time decay. It has a ______________
movement in price versus risk and reward.
A. 1-to-1.
B. 1-to-2.
C. 1-to-10.
D. 1-to-100.
7. True  or  False:  In  a  short  stock  strategy,  when  the  stock  price  falls,
you make money; when it rises, you lose money.
8. A short stock strategy has ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with unlimited risk.
C. High proﬁt potential with unlimited risk.
D. High proﬁt potential with limited risk.
9. True or False: With a long call strategy, when the price of the underly-
ing asset rises you make money; when it falls, you lose money.
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10. A long call strategy has virtually ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with unlimited risk.
C. Unlimited proﬁt potential with unlimited risk.
D. Unlimited proﬁt potential with limited risk.
11. True or False: With a long call strategy, you still have to hold margin
in your account to place the trade.
12.
If  you  bought  a  September  IBM  105  call  for  a  premium  of  5,  yourminimum risk on this trade would be ______________.
A. $50 plus commissions.
B. $100 plus commissions.
C. $500 plus commissions.
D. $1,000 plus commissions.
13. The  breakeven  for  a  long  call  at  expiration  is  computed  by
______________.
A. Adding the cost of the call option to its strike price.
B. Adding cost of the option to the price of the commission.
C. Subtracting the strike price from the option premium.
D. Subtracting the option premium from the strike price.
14. True or False: With a short call strategy, when the underlying instru-ment’s price rises, you make money; when it falls, you lose money.
15. A short call strategy has ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with unlimited risk.
C. Unlimited proﬁt potential with unlimited risk.
D. Unlimited proﬁt potential with limited risk.
16. True  or  False:  With  a  long  put  strategy,  when  the  underlying  instru-ment’s price falls, you make money; when it rises, you lose money.
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17. A long put strategy has virtually ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with unlimited risk.
C. Unlimited proﬁt potential with unlimited risk.
D. Unlimited proﬁt potential with limited risk.
18. The  breakeven  of  a  long  put  option  by  expiration  is  derived  by
______________.
A. Adding the cost of the option to its strike price.
B. Adding the cost of the option to the price of the commission.
C. Subtracting the strike price from the option premium.
D. Subtracting the option premium from its strike price.
19. True  or  False:  In  a  short  put  strategy,  when  the  underlying  instru-ment’s price falls, you make money; when it rises, you lose money.
20. A short put strategy has ______________.
A. Limited proﬁt potential with limited risk.
B. Limited proﬁt potential with signiﬁcant risk.
C. Unlimited proﬁt potential with signiﬁcant risk.
D. Unlimited proﬁt potential with limited risk.
MEDIA ASSIGNMENT
This media assignment requires a piece of graph paper and an Internetconnection.  Once  your  PC  is  booted  and  online,  type  www.cboe.cominto  the  Web  browser,  which  will  take  you  to  the  Chicago  Board  Op-tions  Exchange  web  site.  From  the  CBOE  home  page,  click  on  the“Trading  Tools”  tab,  then  the  “Volatility  Optimizer,”  and  then  click  on“Options Calculator.” Next select “American” in the style box. (Note: Iffor some reason the CBOE site is not available, readers can use any op-tions calculator to complete this assignment.)
On a piece of graph paper (or a printout of an Excel spreadsheet),create  a  risk  graph  by  drawing  a  horizontal  axis  and  a  vertical  axis.Along  the  horizontal  axis,  write  the  numbers  60,  65,  70,  75,  80,  85, and  90  at  evenly  spaced  intervals.  From  bottom  to  top,  write  the 
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numbers  0,  1,  2, . . . , 20  along  the  vertical  axis.  Now,  go  back  to  the options calculator.
Using the chart and the options calculator, let’s create a risk curve fora long call strategy. Remember that a long call is simply the purchase of acall option. So, let’s input some variables into the calculator regarding thislong call. First, let the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quar-terly  dividend  amount  equals  0).  Next,  in  the  “Days  Left  to  Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto  look  at  an  options  contract  with  100  days  remaining  until  expiration,which has a strike price of 75, volatility of 30 percent, and an underlyingsecurity that pays no dividends.
Now, let’s look at what happens to the call option when we changethe  stock  price.  Enter  60  into  the  “Equity  Price”  box  and  look  at  thevalue of the call. It is worth approximately 45 cents. On the risk graph,draw  a  dot  at  the  coordinate  where  60  and  .45  meet  (estimate  .45  be-tween 0 and 1 on the lower left-hand side of the chart). Next, plug thenumber 65 into the “Equity Price” box on the options calculator and no-tice that the value of the long call increases to roughly 1.25. Put a dot onthe risk curve where 65 and 1.25 meet. Continue this process until youreach the stock price of 90. When you reach the ﬁnal equity price valueof 90, the long call is worth roughly