Chapter Test (6 questions, 9 minutes)
(1) Which of the following option positions is least likely to have limited upside potential?
(a) Short call position
(b) Covered call position
(c) Protective put position
(2) The graph of a covered call strategy is similar to the graph of a:
(a) Short call position
(b) Long put position
(c) Short put position
(3) A trader takes a covered call position. He buys the stock for $33 and buys the call option having an exercise price of $40 for $1. What is the maximum profit for the covered call position?
(a) $6
(b) $7
(c) $8
(4) The maximum loss for a protective put position is $12. The position was initiated at a stock price of $108 and an exercise price of $100. What is the premium paid for the put option?
(a) $4
(b) $8
(c) $12
(5) Which of the following positions is most likely to have the least downside potential?
(a) Short put option
(b) Protective put
(c) Covered call
(6) The exercise price of a call option is $45. The call option was purchased when the stock was trading at $40. The breakeven price for the position is $46. What is the premium paid for the call option?
(a) $1
(b) $5
(c) $6
Solutions to the Chapter Test
(1) Correct Answer is C: Short call position has the limited upside potential that is limited to the premium received for the call option. Similarly, there is limited upside potential for the covered call position which is equal to the call option premium plus the difference between the stock price at position initiation and the exercise price. The protective put position has unlimited upside potential.
(2) Correct Answer is C: The graph of a covered call position is identical to the graph of short put position. We can deduce this using the put-call parity equation.
(3) Correct Answer is C: The maximum profit of a covered call position will occur when the stock price rises to the exercise price of the call option or above that. Profit in the long stock position = 40 - 33 = $7. The profit due to selling the call option = $1. Therefore, the maximum profit = 7 + 1 = $8.
(4) Correct Answer is A: The maximum loss for the protective put position will occur when the stock price falls to the exercise price or below the exercise price. When the stock falls to the exercise price, the loss in stock position = 108-100 = $8. The maximum loss includes this loss plus the premium paid for the put option. Therefore, the premium paid for the put option = 12-8 = $4.
(5) Correct Answer is B: Short put option and covered call position have a lot of downside potential. If the stock price goes to zero, then both positions will have huge losses. On the other hand, the protective put is protected on the downside by the put option.
(6) Correct Answer is A: The breakeven price is equal to the exercise price plus the call option premium for a call option. Therefore, the premium for the call option = 46 - 45 = $1.
