
D. All of the above.
24. The price of an option is referred to as the ______________.
A. Premium.
B. Strike price.
C. Bid-ask price.
D. Price-earnings (P/E) ratio.
25. The  ______________  is  deﬁned  as  the  price  at  which  the  stock  orcommodity underlying a call or put option can be purchased or soldover the speciﬁed period.
A. Premium.
B. Strike price.
C. Bid-ask price.
D. Price-earnings (P/E) ratio.
26. An option is no longer valid after its ______________.
A. Payable date.
B. Expiration date.
C. Exercise date.
D. Assignment date.
27. True or False: Options are available on all stocks.
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28. Each stock option (call or put) represents ______________ shares of
a stock.
A. 50.
B. 100.
C. 500.
D. 1,000.
29. True  or  False:  Each  futures  contract  has  a  set  of  unique  speciﬁ-
cations.
30. You must be cautious trading indexes, for a few of them do not have
much ______________.
A. Diversiﬁcation.
B. Liquidity.
C. Cash value.
D. Flexibility.
31. The most important factors for determining opportunity in a market
are ______________.
A. Volume and cash ﬂow.
B. Volatility and cash ﬂow.
C. Liquidity and cash ﬂow.
D. Liquidity and volatility.
32. ______________  gives  you  the  opportunity  to  move  in  and  out  of  a
market with ease.
A. Volatility.
B. Flexibility.
C. An inexpensive option.
D. Liquidity.
33. ______________  measures  the  amount  by  which  an  underlying  is
expected to ﬂuctuate in a given period of time.
A. Volatility.
B. Delta.
C. Theta.
D. Liquidity.
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MEDIA ASSIGNMENT
There  are  numerous  indexes  and  ETFs  available  for  the  options  trader.This chapter provided examples of many of these securities, as well as anintroductory  discussion  of  volatility.  Take  the  time  to  look  at  daily  andweekly price charts of various indexes and ETFs as well as their respec-tive volatility levels. When we look at past movement, we are seeing his-torical  volatility.  However,  by  looking  at  a  chart,  we  can  also  becomepretty good judges of what type of volatility is going to occur in the future.Use  a  charting  program  or  the  Optionetics  web  site  to  eyeball  these  in-dexes  and  ETFs  to  see  which  are  the  most  and  least  volatile.  Learninghow to view charts and access the plethora of information that is availabletakes time, so start by viewing the list of ETFs and indexes listed in thischapter of the main book.
VOCABULARY LIST
Assets
Assignment
Bond
Capital gain
Commodity
Dividend
Historic volatility
Implied volatility
Liability
Liquidity
Option premium
Payable date
Exchange-traded fund (ETF)
Speculator
Stock
Strike price
Exercise
Futures
Hedgers
SOLUTIONS
1. A stock is a unit of ownership in a company. The value of that unit of
ownership is based on a number of factors, including:Answer:  The  total  number  of  outstanding  shares;  the  value  of the  equity  of  the  company  (what  it  owns  less  what  it  owes); is  expected the  earnings  the  company  produces  now  and 
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to  produce  in  the  future;  and  the  demand  for  the  shares  of  the company.Discussion: Stock ownership is a way to participate in the growth ofa  company.  It  has  limited  liability,  yet  many  millionaires  have  beencreated  by  their  stock  ownership.  Fundamental  analysis  can  helpbuy-and-hold  investors  ﬁnd  appropriate  long-term  stocks  to  own.However, short-term traders normally focus more on technical indi-cators that include price and volume and supply and demand issues.
2. Six  people  form  a  company  together  and  decide  that  there  will  beonly six shareholders with only one share each. If this company’s as-sets total $90,000 and it has $15,000 in liabilities, how much is eachshare worth?Answer: B—$12,500.Discussion: Because  the  balance  sheet  says  the  company  is  worth$75,000, each one of the six shares would be worth $12,500 ($75,000 ÷6 = $12,500). This is called book value, but book value is rarely what astock trades for in the stock market. Traders are buying future earn-ings, and this demand normally increases the stock price well aboveits book value.
3. The computerized market, ______________, is also referred to as the
over-the-counter (OTC) market.Answer: C—Nasdaq.Discussion: The Nasdaq is a computerized marketplace, with buyersand sellers brought together through a computer system. Supportersof the Nasdaq believe this is a much more efﬁcient way to exchangethe buying and selling of shares. Whether this is true or not, the Nas-daq trades more volume on a daily basis than the New York Stock Ex-change  (NYSE).  The  Nasdaq  is  best-known  for  being  a  tech-ladenindex. This is because smaller technology companies have been ableto get listed on the Nasdaq more easily than on the NYSE.
4. Supply  and  demand  for  a  company’s  shares  helps  to  create
______________.Answer: C—Liquidity.Discussion: Liquidity is important in the options market, as it helpslessen the spread between the bid and ask prices. It would be impos-sible to sell an option that is being held if there weren’t someone tobuy it from you. Market makers are there to help alleviate this prob-lem, but illiquid stocks and options are still difﬁcult to trade and are
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5.
6.
7.
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best  left  alone.  In  general,  we  don’t  want  to  mess  with  stocks  thathave a volume of less than 300,000 shares a day.
If  investors  feel  a  company  will  beat  Wall  Street  expectations,  thenthe price of the shares will be ______________ as there will be morebuyers than sellers.Answer: C—Bid up.Discussion: The basic economic rule of supply and demand is useddaily in the stock market. When there is an abundance of buyers, thispushes  the  price  higher  until  the  stock  price  ﬁnds  an  equilibriumpoint. When there are more sellers than buyers, the stock price willfall until equilibrium is found to the downside. This is the deﬁnition ofthe free market system and has worked well for centuries. The stockmarket  is  a  great  discounter  of  news,  which  means  expectationsdrive  stock  prices.  Once  an  event  takes  place,  the  stock  trades  onwhat the expectations were more than the actual results.
If  the  majority  of  investors  feel  that  the  company’s  earnings  willdisappoint the Street, then the prices will be ______________.Answer: D—Offer down.Discussion: Sometimes  a  stock  will  gain  ground  when  announcedearnings are not good. This happens because expectations were evenworse  than  the  actual  news.  When  a  stock  disappoints,  though,  ittends to see its stock price offered down as traders jump in to sell onthe negative announcement. Sometimes a stock will announce fantas-tic earnings, but expectations were even higher, so the stock still seesa decline after the announcement.
there  are  more  people  offering 
If  there  are  more  bidders  (buyers),  prices  will  ______________. (sellers),  prices  willIf ______________.Answer: B—Rise. Fall.Discussion: The  price  of  an  investment  will  react  to  the  forces  ofsupply and demand. If there are more buyers than sellers within themarket, and demand is strong, prices move higher. However, wheninvestors are selling and supply is rising, prices tend to fall.
8. A  company’s  board  of  directors  decides  whether  to  declare______________ from time to time to be paid out and distributed toshareholders on a payable date.Answer: D—A dividend.
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Discussion: A dividend is a part of a company’s proﬁt that is passedon to the shareholders. When companies pay part of their proﬁts toshareholders,  those  proﬁts  are  called  dividends.  This  amount  is  an-nounced before it is paid and is distributed to shareholders of recordon  a  per  share  basis.  The  board  of  directors  must  declare  all  divi-dends.  Growth  companies  usually  do  not  offer  dividends,  as  theboard of directors feels the capital is best put to work by investing itback into the company. Utility stocks and other slow moving stockstend to offer the highest dividends. The dividend yield is ﬁgured bytaking the amount of the dividend on an annualized basis and divid-ing it by the stock price.
9. What are the four unofﬁcial size classiﬁcations of stocks?
Answer: Large caps (blue chips), mid-caps, small caps, and micro-caps.Discussion: Large-cap  stocks  represent  companies  with  a  capital-ization  of  more  than  $5  billion.  Also  commonly  referred  to  as  bluechips, large caps are generally mature companies that are regardedas  safe  investments.  They  are  traded  on  the  major  exchanges  andprovide  regular  dividends  to  shareholders—perhaps  their  most  ap-pealing advantage. Mid-cap companies have a market capitalizationof between $500 million and $5 billion. Mid-caps typically experienceslower  growth  than  small  caps  and  faster  growth  than  large  caps.Small caps have a market capitalization of between $150 million and$500 million. They offer traders the opportunity for fast growth andare usually much cheaper than mid-caps or blue-chip stocks. Lowerprices give them the ability to generate dramatic price gains. Micro-cap  stocks  have  a  market  capitalization  of  less  than  $150  million.They can be extremely risky investments because a signiﬁcant per-centage of companies fail early in the development cycle for a vari-ety  of  reasons  including  poor  management,  defective  marketingstrategy, or customer rejection of goods or services offered. Each ofthe four stock size classiﬁcations comes with a unique set of invest-ing objectives.
10. The  ______________,  which  reports  the  performance  of  30  majorcompanies  representing  key  industries,  is  the  most  widely  quotedindicator of market performance.Answer: D—Dow Jones Industrial Average.Discussion: The Dow Jones Industrial Average (DJIA or Dow) is stillthe  quintessential  barometer  of  stock  market  performance  and  isquoted  daily  on  the  evening  news.  While  the  DJIA  has  evolvedthrough  the  years,  the  information  derived  from  it  is  essentially  the
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same. It gauges the stock prices of 30 U.S. companies and reﬂects de-velopments within the U.S. economy. The Dow is a price-weighted in-dex  in  that  the  average  prices  of  all  30  components  are  addedtogether and one ﬁnal average is computed. Though not the best rep-resentative of the broad stock market, the Dow is the most popularindex because it has been around the longest. However, though thereare just 30 stocks represented, this index mirrors the broader marketon a pretty consistent basis. There are times, though, that the Nasdaqand Dow will diverge, and these are important indicators for techni-cal analysts.
11. Name a few stock sectors.
Answer: Technologies,  defense,  retail,  health  care,  ﬁnancials, consumer products.Discussion: There are dozens of different sectors and many subsec-tors. At times a new sector will be created, like Internet stocks. Ana-lysts track various sectors to get a feel for what stocks are bullish andbearish. Not all sectors move in tandem, and analysts can often ﬁndleading indicators for the stock market as a whole by studying indi-vidual sectors. There are many exchange-traded funds (ETFs) and in-dexes that track individual sectors, and many of these are optionable.This allows a trader to choose a direction for an entire sector, ratherthan just one stock within the group.
12. What  is  the  difference  between  a  futures  contract  and  an  options
contract?Answer: A  futures  contract  is  a  promise  to  actually  deliver  or  takedelivery of the underlying commodity. In contrast, the purchase of anoption provides the right, but not the obligation, to buy (call) or sell(put) the underlying instrument.Discussion: Both  futures  and  options  can  be  used  to  make  signiﬁ-cant proﬁts. Futures tend to be employed after a trader becomes fa-miliar  with  options,  but  not  always.  Futures  often  are  consideredmore  complicated,  but  they  really  aren’t;  they  are  just  less  under-stood. Many options traders use futures as the underlying instrumentfor  their  trades.  The  purchase  of  a  futures  contract  comes  with  theobligation to receive delivery of the commodity, bond, or other instru-ment by a speciﬁc date. The sale of a futures contract comes with theobligation to deliver the commodity, bond, or other ﬁnancial instru-ment to the buyer by a certain date. The purchase of an option pro-vides the right, but not an obligation, to buy (in the case of a call) orsell (for a put) the underlying asset.
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13. ______________  were  initially  used  by  farmers  and  producers  ofproducts to hedge themselves or lock in prices for a certain crop orproduct cycle.Answer: B—Futures contracts.Discussion: Individuals or corporations can use futures to get a cer-tain price for a commodity. Farmers use futures to lock in the price ofcorn or wheat a year in advance, which makes it easier to run theirfarms. However, the vast majority of futures traders are now specula-tors who have no interest in making or taking delivery of a product—they are just trying to proﬁt from a directional move in the underlyinginstrument.
14. True or False: Hedgers use futures trading to lock in prices and pro-tect themselves from market movement because they are primarily in-terested in actually receiving or selling the commodities themselves.Answer: True.Discussion: A hedger is an investor who uses the futures market tominimize the risk in his or her business. Hedgers may be manufactur-ers, portfolio managers, bankers, farmers, or others. For example, anoil company can sell its product with a futures contract before it isactually  produced  and  ready  for  sale.  By  purchasing  a  futures  con-tract, the oil company can lock in the prices of oil at a certain point toguarantee the price it will receive.
15. _____________ do not expect to take delivery of a product; they are inthe futures market to try to make money on the price movement of afutures contract.Answer: B—Speculators.Discussion: Unlike  hedgers,  speculators  are  using  futures  to  makeproﬁts, not limit their risk. In fact, these two types of futures tradersneed each other. Hedgers use futures to limit risk, while speculatorsuse risk to make large proﬁts. The two have a symbiotic relationshipthat is necessary to keep the futures market working.
16.
If you believe soybean prices will rise over the next three months,based  on  whatever information  you  may  have,  you  could______________ the corn futures three months out hoping to makea proﬁt.Answer: A—Go long.Discussion: Futures  work  just  like  stocks  or  call  options;  we  wantthe underlying to rise when we buy a futures contract. Of course, like
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the stock market in general, futures will be priced based on the ex-pectations  for  the  commodity.  If  everyone  expects  it  to  be  a  toughwinter, then orange futures might drop in value. However, if you spec-ulate that the winter won’t be as bad as expected, you would beneﬁtfrom buying a future if your belief turns into reality.
If you believe corn prices will fall during this same period, you could______________ the corn futures contract three months out hoping tomake a proﬁt.Answer: B—Go short.Discussion: Going  short  involves  selling  a  futures  contract;  this  isvery risky, akin to shorting stock. However, for experienced traders,shorting a futures contract might make sense. Normally, if we want toparticipate in the down movement of a commodity or stock, we arebest served by buying puts. This strategy limits the position’s risk, butstill provides ample proﬁt opportunities.
18. Physical commodities are any bulk good traded on an exchange or inthe  cash  market;  examples  include  grains,  meats,  metals,  and  ener-gies. ______________ include debt instruments (such as bonds), cur-rencies, and indexes.Answer: C—Financial commodities.Discussion: Financial commodities have become increasingly popu-lar with options traders. A futures contract of a ﬁnancial commodityis an obligation to buy or sell a speciﬁc quantity of currency or someother ﬁnancial instrument for a predetermined price by a designateddate.  Like  any  futures,  those  based  on  ﬁnancial  commodities  aremostly used by speculators, though there are some hedgers who usethem to hedge other holdings. By using options, traders can hedge therisk that comes with the purchase (or sale) of a ﬁnancial commodity.Other physical commodities include the raw materials used in mostretail  and  manufactured  products.  The  ﬁve  major  categories  aregrains, metals, energies, raw foods, and meats. Some are seasonal innature (heating oil, for instance), which causes demand to ﬂuctuatebased  on  the  time  of  year  and  climactic  conditions.  Others  react  tospeciﬁc  events;  a  drought  in  the  Midwest  can  send  grain  pricessoaring. Commodities are also highly leveraged investments. A smallamount of cash can control many times its face value in commoditiescontracts. But this works both ways, creating huge potential wins andlosses. Futures are used by farmers and holders to hedge prices inthe  future,  but  futures  on  physical  commodities  still  have  plenty  of
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speculators as well. The Chicago Board of Trade (CBOT) is the majorexchange for these commodities.
19. The value of ______________ primarily depends on interest rates.
Answer: D—All of the above (bonds, debt instruments, Eurodollars).Discussion: All  of  these  commodities  depend  on  interest  rates.For  example,  when  interest  rates  go  up,  bond  (loan)  prices  fall.Conversely, when interest rates fall below the interest rate guaran-teed on a speciﬁc bond, that bond increases in value. Since interestrates can change the value of these instruments drastically, holdersof  these  instruments  will  hedge  their  risk  by  using  options  andfutures on interest rates and individual commodities like bonds orcurrencies.
20. Typically,  there  is  an  inverse  relationship  between  ______________
and most foreign currencies.Answer: A—The U.S. dollar.Discussion: Money  is  greatly  affected  by  international  rates  of  ex-change.  The  value  of  a  country’s  currency  ﬂuctuates  in  relation  tovalues  of  foreign  currencies.  An  inverse  relationship  usually  existsbetween  the  dollar  and  other  currencies.  If  the  dollar  falls,  foreigncurrencies may increase in value. For example, if the U.S. dollar isweak in comparison to the yen, the prices of Japanese products im-ported to the United States will increase. If the dollar is high in com-parison  to  the  euro,  the  prices  of  American  products  exported  toEurope  will  rise.  An  inverse  relationship  is  created  because  of  thelarge amount of imports and exports that the United States partici-pates in. Currencies are traded by large ﬁnancial institutions lookingfor  the  best  rate  of  exchange.  Since  a  change  in  the  exchange  ratecan  create  such  a  huge  variance  for  multinational  ﬁrms,  many  ofthese corporations use futures to hedge their risk. Of course, thosetraders who have a strong understanding of foreign currencies canalso speculate on future changes in the value of the dollar as opposedto other currencies.
21. A/an  ______________  is  an  indicator  that  is  used  to  measure  andreport  value  changes  in  a  speciﬁc  group  of  stocks,  commodities,  ordifferent sectors of the marketplace.Answer: C—Index.Discussion: An index is a select group of stocks that measures andreports value changes to the group as a whole. A variety of indexes
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are  tailored  to  reﬂect  the  performance  of  many  different  sectors  ofthe marketplace, such as the S&P 500 ($SPX) or the New York StockExchange Composite Index ($NYA). While these indexes are used togauge trends within the stock market, some indexes are designed tomeasure the price changes of speciﬁc industry groups. Indexes havebecome increasingly popular over the past 20 years, partly due to theincreased volume of shares traded on the exchanges and the ease ofcreating an index with the proliferation of computers. Regardless ofwhy  there  are  so  many  indexes,  their  use  has  become  widespread.Most major exchanges have options and futures available on them, al-lowing a knowledgeable trader plenty of opportunities to hedge riskand make large proﬁts.
22. By combining futures with ______________, you can create trades in
which you limit your risk and maximize your potential proﬁts.Answer: A—Options.Discussion: Options are the perfect trading instrument for leveragingyour capital and hedging stocks and futures against risk. They act toprotect your investments just as buying insurance would for your caror home. Many of us probably could have done a better job “insuring”our  portfolios  against  losses,  but  only  hindsight  is  20/20.  To  be  suc-cessful in today’s markets, you need to evaluate your current positionsto see what you can do to be more successful moving forward.
23. ______________ are contracts between two parties that convey to thebuyer a right, but not an obligation, to buy or sell a speciﬁc commod-ity or stock at a speciﬁc price within a speciﬁc time period for a pre-mium.Answer: C—Options.Discussion: The key to this deﬁnition is that the buyer has the right,but not the obligation, to buy or sell the underlying asset by a certaintime. This varies from a futures contract where there is an obligation.Options are unique and very versatile instruments that can be used tohedge risk and make substantial proﬁts. However, like all profession-als, options traders need to learn their craft and use discipline.
24. The price of an option is referred to as the ______________.
Answer: A—Premium.Discussion: This is a ﬁtting name, as the same term is also used for in-surance. This makes sense since options are often used as insurance
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to protect long-term holdings. When buying a call option, we have theright to buy the underlying security at a future date at a speciﬁc price.We do not have to use this right, just as we don’t always use our in-surance  policies  (i.e.,  ﬁle  a  claim),  but  the  option  is  there  if  we  dowant to use it.
25. The ______________ is referred to as the price at which the stock orcommodity underlying a call or put option can be purchased or soldover the speciﬁed period.Answer: B—Strike price.Discussion: The strike price has a distinct relationship to the priceof an option. If the strike price is a long ways away from the currentvalue of the security, the premium will be low. However, if there al-ready is value in the option because it is in-the-money (ITM), the pre-mium will be much higher.
26. An option is no longer valid after its ______________.
Answer: B—Expiration date.Discussion: Once an option hits its expiration date, which is close ofbusiness  prior  to  the  Saturday  following  the  third  Friday  of  eachmonth, it can no longer be exercised. If an option is out-of-the-money(OTM) at expiration, it will no longer have any value. However, if it isITM, the option holder will need to either sell it for its current valueor exercise the option to fulﬁll the contract. Most options contractsare bought and sold before expiration.
27. True or False: Options are available on all stocks.
Answer: False.Discussion: Options  are  not  always  available  on  every  stock.  Op-tions are often added to new stocks, but only about 40 percent of cur-rent stocks traded on the major exchanges or optionable. If a stockhas little liquidity, there is very little reason to start trading options onthe stock. The CBOE web site has a list of new optionable stocks thatcan be viewed or e-mailed to you each day.
28. Each stock option (call or put) represents ______________ shares of
a stock.Answer: B—100.Discussion: Generally a stock option represents 100 shares of stock.Thus, if a call option is quoted at $2, the total cost for one contract
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would be $200. If the stock is trading for $20, this means we are con-trolling $2,000 worth of stock for $200, which is leverage of 10-to-1.This  allows  options  traders  to  make  large  proﬁts  without  an  over-whelming amount of risk.
29. True or False: Each futures contract has a set of unique speciﬁcations.
Answer: True.Discussion: You are responsible for understanding the speciﬁcationsfor each futures market. Each commodity has different speciﬁcationswhen it comes to futures. This makes sense, as different commoditiesare  measured  in  different  ways.  With  stock,  we  have  a  share;  withgold,  we  measure  it  by  the  ounce.  Thus,  each  futures  contract  canhave a different ratio that needs to be calculated to come up with thepremium and underlying value.
30. You must be cautious trading indexes, for a few of them do not have
much ______________.Answer: B—Liquidity.Discussion: We  need  to  be  cautious  not  only  with  indexes  that  donot have much liquidity, but with any underlying security that is illiq-uid. A lack of liquidity creates higher bid-ask spreads and also leadsto a great deal of volatility. When there is little interest in a security orindex, it is more difﬁcult to get a good ﬁll when you are ready to sell.
31. The most important factors for determining opportunity in a market
are ______________.Answer: D—Liquidity and volatility.Discussion: Liquidity is the measure of trading volume of an invest-ment security. As a general rule, the more trading volume associatedwith  an  investment,  the  more  liquid,  and  the  better  the  market.Volatility is a measure of the speed or movement in a market. A veryvolatile  market  moves  fast  and  can  provide  a  trader  with  a  greaternumber of proﬁt-making opportunities