Chapter 4 Practice Question Answers

1. 1. Answer: A. On long calls, an investor’s maximum gain is unlimited.
2. 2. Answer: B. On long calls, an investor’s breakeven is the strike price plus the premium paid. Thus, Sally’s breakeven is 32.50 (30 + 2.50).
3. 3. Answer: B. For naked short calls, the investor’s maximum gain is the premium received. In this case, Jon receives $1,050 (3 x 3.50 x 100).
4. 4. Answer: C. When an investor is bullish it means that she expects the price of the stock to rise. Investors who are bullish have long positions in a stock. They also buy calls and sell puts.
5. 5. Answer: D. On short puts, an investor’s maximum loss is the strike price minus the premiums times the number of contracts times 100, which in this case is $11,000 ((30 – 2.5) x 4 x 100).
6. 6. Answer: B. For puts, an option is in-the-money when the market price is below the strike price. In this case, the market price is above the strike price, so the option is out-of-the-money.
7. 7. Answer: B. If an investor has a long position in a stock, he can increase his income by writing calls on this stock. These are called covered calls.
8. 8. Answer: C. For both long and short positions, put options are in-the-money when the market price is below the strike price. The intrinsic value is the amount that a stock is in-the-money. When an option is out-of-the-money, the intrinsic value is always equal to $0. Because this option is out-of-the-money, its intrinsic value is $0.
9. 9. Answer: A. Investors typically hedge long positions with puts. If Jon is long 300 shares of ABC, three ABC puts will fully hedge his position.
10. 10. Answer: D. When Jon opens his position, he takes in $1,050 (3 x $350). When the options are exercised, he must go into the market and buy 300 shares at 52 and immediately sell them to the holder of the call at 50 at a $600 loss. Thus, he nets $450 ($1,050 – $600).
11. 11. Answer: A. When Casey opens her position, she pay