ing short.C. Going delta neutral.D. Hedging.
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THE OPTIONS COURSE WORKBOOK
26. If you sell call options, you are ______________.A. Going long.B. Going short.C. Going delta neutral.D. Hedging.
27. If you are ______________ (believe the market will rise), then youwant to buy calls.A. Bearish.B. Bullish.
28. If you are ______________ (believe the market will drop), then youwant to buy puts.A. Bearish.B. Bullish.
29. If you buy a call option, your risk is ______________.A. Unlimited.B. The price of the underlying.C. The margin of the underlying.D. The price of the premium.
30. If you sell a call option, your risk is ______________.A. Unlimited.B. The price of the underlying.C. The margin of the underlying.D. The price of the premium.
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Option Basics
31. If the current price of XYZ is $50, fill in the blanks designating eachstrike as ITM, ATM, or OTM.Strike Price of Option
Call Option Moneyness
706560555045403530
32. Name the two ways profits can be realized from purchasing a calloption.1. _________________________________________________________2. _________________________________________________________
33. All the options that have the same unit of trading, expiration date,and strike price are called an ______________.A. Option class.B. Option series.C. Option division.D. Option suit.
34. A ______________ gives the buyer the right (not the obligation) to sellthe underlying stock shares or futures contract.A. Call option.B. Put option.C. Futures option contract.D. Stock option contract.
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35. If the market price is less than your strike price, your put option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.36. If the market price is more than your strike price, your put option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.37. If the market price is the same as your strike price, your put option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.38. If you buy put options, you are ______________.A. Going long.B. Going short.C. Going delta neutral.D. Hedging.39. If you sell put options, you are ______________.A. Going long.B. Going short.C. Going delta neutral.D. Hedging.40. If you buy a put option, your risk is ______________.A. Unlimited.B. The price of the underlying.C. The margin of the underlying.D. The price of the premium.
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Option Basics
41. If you sell a put option, your risk is ______________.A. Limited to the stock falling to zero.B. The price of the underlying.C. The margin of the underlying.D. The price of the premium.42. If the current price of XYZ is $50, fill in the blanks designating eachstrike as ITM, ATM, or OTM.Strike Price of Option
Put Option Moneyness
706560555045403530
MEDIA ASSIGNMENTIn order to better understand the basics of puts and calls, let’s go to theOptionetics.com web site and create an option chain. First, connect tothe Internet and type www.optionetics.com into the title bar of your Webbrowser. Next, type a symbol for the stock or index of your choice in thequote box that appears at the top of the home page. For instance, usethe symbol QQQ. Finally, select “Chain” from the drop-down menu andclick “Go.”After clicking “Go,” an option chain for the Nasdaq 100 QQQ will appear inside your web browser. First, notice that the chain is clearly separated down the middle and consists of two groups of columns. In order tosee the latest price quotes for call options on the QQQ, the strategistneeds to look at the left side of the chain. To find information on QQQputs, one would look to the right.Next, notice that the first rows of options list the options with theshortest amount of time remaining until expiration. For instance, if you
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THE OPTIONS COURSE WORKBOOK
create this chain on January 1, 2005, the January 2005 options will appearat the top of the table. In addition, these options will be sorted based onstrike price. As you move down the table, you will notice that the expiration dates change. The options with the most time remaining until expiration appear in the last rows of the table. The option chain also providesthe option symbol, the bid price, the asking price, and the open interestfor each option.
VOCABULARY LISTAmerican-style
Intrinsic value
Assignment
Long
At-the-money
Moneyness
Automatic exercise
Near-the-money
Credit
Out-of-the-money
Debit
Root symbol
European-style
Series
Exercise
Short
Expiration date
Strike price
In-the-money
Symbol
SOLUTIONS1. A ______________ gives the buyer the right, but not the obligation, tobuy a specified number of shares or contracts of the underlying security at a predetermined price during a set period of time.Answer: B—Call option.Discussion: A call is a type of options contract that can be purchased or sold. The owner of a call option purchases the right, butnot the obligation, to buy a specified amount of the underlying security (e.g., 100 shares of XYZ stock) at a predetermined price for aspecified period of time.
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41
2. If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.Answer: D—Premium.Discussion: The premium is the amount paid by the option buyerand the amount received by the option seller when entering into thecontract. There are seven major components that affect the premiumof an option:1. The current price of the underlying financial instrument.2. The type of option (put or call).3. The strike price of the option in comparison to the current marketprice (intrinsic value).4. The amount of time remaining until expiration (time value).5. The current risk-free interest rate.6. The volatility of the underlying financial instrument.7. The dividend rate, if any, of the underlying financial instrument.3. True or False: Options are available on all stocks.Answer: False.Discussion: Options are not available on every stock. Check withyour broker or look for an option chain using www.optionetics.comto see if a stock you are interested in trading has available options.4. True or False: Once you own an option, you are obligated to buy orsell the underlying instrument.Answer: False.Discussion: An option holder is not obligated to buy or sell the underlying instrument. The purchase of an option gives you the right—but not the obligation—to buy or sell the underlying. If you choosenot to exercise it, you can simply let the option expire worthless.5. Once an option ______________, you lose your right to buy or sell theunderlying instrument at the specified price.Answer: C—Expires.Discussion: After expiration, the option ceases to exist. Therefore,the owner then has no rights and the seller has no obligation associated with the contract.
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6. Options when bought are done so at a ______________ to the buyer.Answer: A—Debit.Discussion: If a trader buys an option, the cost of the option—thepremium—is debited from the trader’s account.7. Options when sold are done so by giving a ______________ to theseller.Answer: B—Credit.Discussion: If a trader sells an option, the cost of the option—thepremium—is credited to the trader’s brokerage account. For example, the call’s premium is the maximum profit available on a short option position and shows up as a credit in the trader’s account.8. Options are available at numerous ______________ based on theprice of the underlying instrument.Answer: D—Strike prices.Discussion: Options are assigned various strike prices that are basedon the current market price of the underlying asset. The strike priceis the fixed price at which the asset underlying an option can bepurchased (call) or sold (put).9. The more time until expiration, the more ______________ thepremium.Answer: A—Expensive.Discussion: An options contract with many months or years remaining until expiration will be worth more than an options contract withonly a few days or weeks remaining. Stated differently, the more timeremaining in the option’s life, the greater the option’s value and therefore the greater the option premium.10. True or False: Strike prices for stocks and indexes come only inmultiples of 5.Answer: False.Discussion: Strike prices may vary for stocks and indexes. In general, however, options are available at various strike prices at 2 1/2point intervals for stocks priced $25 and less, or 5-point intervals forstocks over $25.
Option Basics
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11. Name the three possible relationships strike prices have to the current price of the underlying asset.Answer: In-the-money (ITM), at-the-money (ATM), out-of-the-money(OTM).Discussion: Moneyness refers to the option’s strike price relative tothe price of the underlying asset. If the strike price is equal to theprice of the underlying asset, the option is said to be at-the-money. Ifthe strike price is higher or lower than the underlying asset price, theoption is either out-of-the-money or in-the-money depending onwhether the option is a put or a call.12. What is the main difference between American-style options andEuropean-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 underlying stock rises above a short call strike price before expiration, 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 selling naked options.
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14. 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 expiration 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 theyrepresent.Answer: True.Discussion: Different underlying assets (stocks, indexes, futures,etc.) have different specifications for their respective options contracts. 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 expiration 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 January 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 underlying asset.21. A ______________ gives the buyer the right (not the obligation) to buythe 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. 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.24. 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 underlying asset, whether puts or calls, the contract is at-the-money.25. 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.26. 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.27. 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.28. 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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Option Basics
fall. A falling market is called bearish because bears swat downwardwith their paws.29. 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).30. If you sell a call option, your risk is ______________.Answer: A—Unlimited.Discussion: Call option sellers enter into an obligation to sell the underlying 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
OTM
65
OTM
60
OTM
55
OTM
50
ATM
45
ITM
40
ITM
35
ITM
30
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-themoney. If the strike price is lower than the underlying asset price, thecall option is in-the-money.
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THE OPTIONS COURSE WORKBOOK
32. Name the two ways profits can be realized from purchasing a calloption.Answer:1. If the underlying asset increases in price before the option expires, the holder can purchase the underlying asset at the lowerstrike price.2. 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 contract or close the position by selling the same number of an identical 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 market for $100. Alternatively, the trader could sell 10 IBM January 90calls and close the position at a profit without exercising the options. 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 underlying asset that have the same unit of trading, strike price, andexpiration date.34. A ______________ gives the buyer the right (not the obligation) to sellthe 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.
Option Basics
49
36. 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.
37. 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.
38. 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.
39. 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.
40. 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.
41. 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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THE OPTIONS COURSE WORKBOOK
42. 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
ITM
65
ITM
60
ITM
55
ITM
50
ATM
45
OTM
40
OTM
35
OTM
30
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 ASSIGNMENTNow that we have created an option chain, let’s make a few observations. First, notice that the premiums of the calls with the same expiration 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 premiums 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,
Option Basics
51
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 DEFINITIONSAmerican-style: An options contract that settles American-style canbe exercised at any time prior to expiration. Stock options settleAmerican-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 Saturday 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-ofthe-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-themoney, 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 underlying 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 specified period.Symbol: A three-, four-, or five-letter sequence that denotes a stock, option,or futures contract.
CHAPTER 4
BasicTradingStrategies
SUMMARYIn 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 strategies, 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 EXERCISES1. 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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THE OPTIONS COURSE WORKBOOK
2. Reading a risk profile is pretty easy. The horizontal numbers atthe 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.
Basic Trading Strategies
55
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 underlying 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 marginin 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 instrument’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 instrument’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