Table of Contents
Question 183: Covered call and protective put ..................................................... 2
Question 184: Option spread trades .................................................................. 5
Question 185: Option combination trades ........................................................... 8
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Long call
Short call
Long put
Short put
183.2. The profit pattern of a protective put is most similar to the pattern of which naked option
trade?
a)
b)
c)
d)
Long call
Short call
Long put
Short put
183.3. A nine-month call option with a strike price of $22.00 has a price (option premium) of
$4.00 when the underlying stock price is $21.00. If a trader writes a covered call (i.e., with the
OTM call option), what are, respectively, the maximum net profit (reward) and the maximum net
loss (risk) possible? note: consistent with Hulls profit pattern charts, please disregard the time
value of money.
a)
b)
c)
d)
183.4. A six-month put option with a strike price of $14.00 has a price (option premium) of
$2.00 when the underlying stock price is $18.00. If a trader employs a protective put strategy
(i.e., with the OTM put option), what are, respectively, the maximum net profit (reward) and the
maximum net loss (risk) possible? note: consistent with profit pattern charts, please disregard
the time value of money.
a)
b)
c)
d)
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183.5. The current price of a non-dividend-paying stock is $20.00 and the price of a six-month
European call option on the stock with a strike price of $20.00 (ATM) is $3.00. The riskfree rate
is 4.0%. What is the total initial cost to enter a protective put if we assume the trade includes a
six-month ATM put?
a)
b)
c)
d)
$3.60
$16.70
$22.00
$22.60
183.6. The current price of a non-dividend-paying stock is $20.00 and the price of a six-month
European put option on the stock with a strike price of $20.00 (ATM) is $2.00. The riskfree rate
is 4.0%. What is the total initial cost to write a covered call if we assume the trade includes a sixmonth ATM call?
a)
b)
c)
d)
$2.00
$12.40
$17.60
$22.00
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Answers:
183.1. D. Written cover call resembles a short put (note both are income strategies)
Put call parity gives: p+ S(0) = c + K*exp(-rT), which re-arranges to:
S(0) - c = K*exp(-rT) - p.
The left-hand side is a covered call, which shows as Hull writes that a long position in a stock
combined with a short position in a call [i.e., a covered call] is equivalent to a short put position
plus a certain amount of cash. This equality explains why the profit pattern [of a covered call] is
similar to the profit pattern from a short put position.
183.2. A. Long call
Per put-call parity gives: p+ S(0) = c + K*exp(-rT).
As the left-hand side is a protective put, this shows as Hull writes that a long position in a put
combined with a long position in the stock [i.e., protective put] is equivalent to a long call
position plus a certain amount of cash.
183.3. A. $5 (max net profit) and -$17 (max net loss)
On the upside, the gain is capped at $4 for the collected premium on the written call + $1 on the
difference between $22 and $21.
On the downside, the worst case is the stock drops to zero which implies a loss of $21 on the
purchased stock but mitigated by the $4 collected premium ($17 = $21 - 4); the written option
will not be expired.
The covered call is an income strategy: in exchange for the extra income of the option premium
received, the upside is capped.
183.4. B. unlimited (max net profit) and -$6 (max net loss)
The upside is unlimited: the purchased put reduces the net profit by the premium, but the profit
is still unlimited.
On the downside, loss is -2 for the option premium paid plus -4 (14 - 18 = -4) equals capped
downside of a loss of $6.
The protective put is an insurance strategy; in exchange for forgoing upside (option premium
paid) the loss is capped.
183.5. D. $22.60
Per put-call parity the protective put = S(0) + p = c + K*exp(-rT) = 3 + 20*exp(-4%*0.5) =
$22.603
183.6. C. $17.60
Per put-call parity S(0) + p = c + K*exp(-rT), such that a written call is given by:
S(0) - c = K*exp(-rT) - p = 20*exp(-rT) - 2 = $17.60; i.e., the call price is $2.40 and $20 - $2.40 =
$17.60.
That is, pay for the stock @ $20 and collect $2.40 in call premium.
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85%
187%
281%
364%
184.2. Assume two OTM put options on an stock with a current price of $30: the first put option
has a strike at $25 and costs $1, the second put option has a strike at $28 and costs $2. Ignoring
the time value of money, if an investor enters a BEAR SPREAD trade, at what future stock price
does the strategy break-even (break-even is when the strategys profit is zero)?
a)
b)
c)
d)
$26
$27
$28
$29
184.3. The stock of ACME company is currently trading at $20.00. At a strike price of $16.00, a
call option costs $6.00 and a put option costs $1.37. At a strike of $24.00, a call option costs
$1.20 and a put option costs $4.26. All of the options are European with one year to expiration.
The risk-free rate is 4.0% per annum continuously compounded. What is the present value (PV)
of the future PAYOFF of a BOX SPREAD strategy (note: while profit nets the initial cost, payoff
does not net the initial cost)
a)
b)
c)
d)
Zero
$1.15
$7.69
$8.00
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184.4. Two traders each employ CALENDAR SPREAD trades with identical shorter-dated and
longer-dated maturities: Trader C employs a calendar spread with a three-month and a ninemonth call option, while Trader P employs a calendar spread with a three-month and a ninemonth put option; for all options, the strike are at $20.00 which is at-the-money (ATM). When
the shorter-maturity options expires in three months, which scenario is most profitable (profit
net of initial cost) to the traders?
a) For both traders, if the stock is well ABOVE the $20 strike
b) For both traders, if the stock is well BELOW the $20 strike
c) For the trader using calls, if the stock is well above $20; for the trader using puts, if the
184.6. The stock of ACME company is currently trading at $20.00. There are three call options on
the stock: an ITM call option with a strike at $16.00 costs $5.00; an ATM call option with a strike
at $20.00 costs $2.45; and an OTM call option with a strike at $24.00 costs $1.00. If an investor
enters a long call BUTTERFLY SPREAD trade, what is the maximum return on investment (ROI)
where ROI = maximum profit / initial cost, without regard to time value of money?
a)
b)
c)
d)
93%
167%
265%
233%
184.7. With respect to option spread trade strategies, consider the following statements:
I.
II.
III.
IV.
A long call option plus a short call option on the same stock can create the
following trades: bull spread, bear spread, calendar spread, and diagonal spread
In the case of a bull or bear spread, the call options have the same expiration date
but different strike prices
In the case of a calendar spread, the call options have the same strike price but
different expiration dates
In the case of a diagonal spread, the call options have both different strike prices
and different expiration dates
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Answers:
184.1. C. 281%
Bull spread: BUY call option with lower strike (K = 22) and SELL call option with higher strike
price (K = 26).
Initial cost = buy $2 call and sell $0.95 call = $1.05 net initial cost
Maximum profit = max payoff - initial cost = (difference in strike prices) - initial cost = $4.00 $1.05 = $2.95
Maximum ROI = 2.95/1.05 = 281%
184.2. B. $27
The initial cost of the bear spread is $1 as it costs $2 to purchase the put with the higher strike
price and $1 is received by selling the other put.
Therefore, break-even occurs if the stock price reaches $27 because, while one put option is
OTM, the other is exercised for a $1 gain.
(in briefer terms, breakeven stock price for a bear spread = higher strike price - initial cost = 28 1 = $27)
184.3. C. $7.69, which is the initial cost of the strategy
Because the box spread is not profitable, the PV(future payoff) must equal the initial cost. In this
case,
Initial cost = pay (6.00 + 4.26) and receive (1.37 + 1.20) = 10.26 - 2.57 = $7.69;
(Future) payoff of box spread = difference in strike prices = 24 - 16 = $8.00, and
$7.69 = $8.00*exp(-4%*1), such that PV (payoff) = initial cost = $7.69, which gives profit of zero
(if we incorporate time value of money; please note that without time value of money, profit = 8
- 7.69 = $0.31)
184.4. D. If the stock is near or equal to the $20 strike, for both traders
For calendar spread trades (employing either calls or puts), the strategy is most profitable when
the stock price equals the strike prices when the short-dated option expires; i.e., in that case, the
sold option expires worthlessly and the purchased option still has value (time value).
184.5. A. Bull spread with puts. An income strategy: at high stock prices, neither option is
exercised and the initial receipt is retained.
In regard to (B), neither option is exercised but the initial cost represents a loss (this strategy is
a bet on a price decline).
In regard to (C) and (D), both the butterfly and calendar spread strategies imply net losses given
extreme price moves in either directions.
184.6. C. 265%
Long call butterfly spread = Long ITM call + Long OTM call + Short Two ATM calls. In this case:
Initial cost = $5 + $1 - (2 * 2.45) = $1.10
Max payoff occurs if remains at the middle strike price of $20, in which case future payoff (due
to ITM call) = $4.00.
Max profit = $4.00 - $1.10 = $2.90, such that max ROI = 2.90/1.10 = 265%
184.7. D. All of the above
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185.2. An investor purchases a (bottom) straddle with at-the-money (ATM) options. The
percentage delta (i.e., delta per option) of the ATM call option is + 0.62; for example, if she
purchases 100 call options, then the position delta is 0.62 percentage delta * 100 options = +62
position delta. At the time of purchase, what is the position delta of the long straddle?
a)
b)
c)
d)
Negative
Zero
Positive
Need more information
185.3. John predicts that Groupons stock (ticker: GRPN) is going to see big move, soon, in either
direction: he thinks the stock should either spike up, or plummet, dramatically. He therefore
predicts the stock will do anything except remain range-bound. His plan is to purchase straddles.
His college Andrea argues for a STRANGLE instead. Her argument in favor of a strangle, over a
straddle, employs each of the following EXCEPT:
a) The strangle has a lower initial investment (total premiums) than the straddle
b) As the stock moves up or down, the strangle reaches breakeven sooner (requires less
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A strip is a straddle plus long one put option, and is therefore bearish
A strap is a straddle plus long one call option, and is therefore bullish
Both the strip and strap are volatility trades: uncapped potential reward under big
price moves but a losing trade under range-bound scenarios
Both the strip and strap are cheaper than the straddle
I. and III.
II. and IV.
I., II. and III.
All of them
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Answers:
185.1. D. $2.30 (max risk) and $17.70 (max reward)
Did you remember to use put-call parity to infer the price of the put (a straddle is the long/short
of call and put with same strike and remaining term)?
As p = c + K*exp(-rT) - S, in this case, p = 1.25 + 20*exp(-4%*0.25) - 20 = $1.05.
The maximum risk is the total initial (option premiums) investment = $1.25 + $1.05 = $2.30.
The maximum reward, while sometimes consider uncapped (this is really virtually), occurs if
the stock drops to zero, such that max reward = $20.00 max payoff on the put - $2.30 investment
= $17.70.
185.2. C. Positive
Since the call and put have the same strike and expiration (and the underlying asset price and
volatility are the same), we should know that delta put = delta call -1; i.e., delta put = N(d1) -1.
Technically, this is an FRM Part 2 (Level 2) concept but delta has Part 2 influences and youll
need to know this anyway, this is useful!
In this case, as the percentage delta of the call is 0.62, the percentage delta of the put is 0.62 - 1 =
-0.38.
Regardless of the quantity, the position delta is positive, somewhere between the call delta and
the put delta:
Percentage delta of long straddle = [0.62 + (-0.38)] = 0.24
Position delta of long straddle = [0.62 + (-0.38)] * quantity of options = 0.24 * quantity of options
Please note this only applies immediately, while both call and put are ATM, the deltas vary as the
underlying varies so the straddle delta can go negative as the underlying price drops; e.g., at a
very low stock price, the investor is long deep OTM calls (delta approaching zero) plus long deep
ITM puts (delta approaching -1.0).
185.3. B. False. The disadvantage of the strangle is that breakeven points are further
apart, than under the straddle. (the strangle purchases two OTM options: this lowers the
total premium at the cost of widening the breakeven points).
In regard to (A), (C) and (D), there are EACH advantages of the strangle over the straddle; please
note (A) and (C) are identical really.,
185.4. C. I., II. and III.
In regard to (D), as the strip and strap require the purchase of three options instead of two,
these strategies are more expensive initially than the straddle.
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