Deck 15: Option Trading Strategies

Question 1

Identify the INCORRECT statement about spread strategies created by trading options of the same type (either all calls or all puts)on the same underlying with identical terms (unless noted otherwise):

A) Vertical spreads (also called money,perpendicular,or price spreads)are established by buying one option and selling another option with a different strike price.
B) Horizontal spreads (or,time or calendar spreads)are established by buying one option and selling another option with the same strike but different maturity dates.
C) Diagonal spreads are established by buying one option and selling another option that differ both in terms of strike price and maturity dates.
D) A butterfly spread is created by trading four options with three different strike prices: two options with extreme strike prices are bought (written)and two options are written (bought)with the middle strike price.
E) A condor spread is created by trading four options with three different strike prices: two options with extreme strike prices are bought (written)and two options are written (bought)with the same middle strike price.

Answer 1

E

Question 2

CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
If a hurricane hits,the maximum amount that the insurance company CatIns can lose per home in a given year would be:

A) $275,000
B) $300,000
C) $370,000
D) $380,000
E) None of these answers are correct.

Answer 2

C

Question 3

Which of the following statements regarding Warren Buffett's views and experiences with derivatives is INCORRECT?

A) Buffett has characterized derivatives as "time bombs,both for the parties that deal in them and the economic system."
B) Buffett declared that all derivatives should be outlawed.
C) Under chairman Buffett's supervision,Berkshire Hathaway has written more than 200 long maturity derivatives on major indexes.
D) Buffett sold derivatives because he felt that these contracts were "mispriced at inception,sometimes dramatically so" and viewed them as similar to arbitrage opportunities.
E) Buffett's company is extensively involved in reinsurance-activities that are similar to trading put options.

Answer 3

B

Question 4

CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
Suppose that the insurance company CatIns buys reinsurance that pays for hurricane losses to a home over $150,000 for a premium of $5,000 payable to a reinsurance company.If the company has insured 200,000 homes,the maximum amount that CatIns can lose would be:

A) $12.5 billion for "Loss per home" of $100,000 or more
B) $15 billion for "Loss per home" of $150,000 or more
C) $25 billion for "Loss per home" of $150,000 or more
D) $35 billion for "Loss per home" of $200,000 or more
E) None of these answers are correct.

Question 5

A European call on OPSY stock with a strike price of $22.50 is worth $1.75.Let the present value of the strike price be $22.25.A European put on the stock with identical terms is worth the same.If the price of OPSY stock is $22,the arbitrage profit that you can create today by trading the stock and other related securities is:

A) $0.25
B) $0.50
C) $0.75
D) $1
E) None of these answers are correct.

Question 6

Goldminers Inc.mines and refines ore and sells pure gold in the global market.To raise funds,it sells a derivative security whose payoff is as follows: •Part of the security is a zero-coupon bond (which is sold at a discount and makes no interest payments)that pays a principal of $1,000 at maturity T.
•Goldminers also pays an additional amount that is indexed to gold's price (per ounce)at maturity S(T):
0
If S(T) $\le$ $1,550
20[S(T)- 1,550]
If $1,550<S(T) $\le$ $1,600
1,000
If $1,600<S(T).
This derivative can be written as a combination of:

A) (1)a long zero-coupon bond with face value $2,000, (2)long 20 European puts with strike price $1,600,and (3)short 20 European puts with strike price $1,550
B) (1)a long zero-coupon bond with face value $2,500, (2)short 20 European puts with strike price $1,600,and (3)long 20 European puts with strike price $1,550
C) (1)a long zero-coupon bond with face value $1,000, (2)long 20 European calls with strike price of $1,550,and (3)short 20 European calls with strike price $1,600
D) (1)a long zero-coupon bond with face value $1,500, (2)long 20 European calls with strike price of $1,550,and (3)short 20 European calls with strike price $1,600
E) None of these answers are correct.

Question 7

CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
An insurance company has insured oil fields in the Mideast (which includes Iran,Iraq,Kuwait,Saudi Arabia,and United Arab Emirates).Next,it purchases reinsurance to manage its "tail risk." The reinsurance company decides to hedge some of its risks by trading derivatives.In this context,which derivative trade is unlikely to be effective?

A) buy oil futures
B) buy call options on oil futures
C) sell oil futures
D) sell put options on oil futures
E) enter into a commodity swap where the insurance party receives an average oil price in exchange for a fixed rate payment

Question 8

Which of the following statements is INCORRECT about covered call writing?

A) Covered call writing is known as a buy-write if one simultaneously buys the stock and sells the call,but it's an overwrite if one sells the call after purchasing the share.
B) The Chicago Board Options Exchange's S&P 500 BuyWrite Index (BXM)is a benchmark for measuring the performance of covered call writing strategies.
C) Covered call writing is considered a speculative strategy whose objective is to beat the market.
D) Covered call writing is considered a hedge strategy.
E) Many traders write covered calls to generate extra income.

Question 9

CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
Suppose that the insurance company CatIns buys reinsurance that pays for hurricane losses to a home over $150,000 for a premium of $5,000 payable to a reinsurance company.Then the profit diagram for CatIns would be similar to:

A) a bearish call spread on the hurricane losses
B) a bullish call spread on the hurricane losses
C) a butterfly spread on the hurricane losses
D) a condor spread on the hurricane losses
E) None of these answers are correct.

Question 10

Suppose you write a covered put option by depositing a cash amount equal to the strike price in your brokerage account.Then which of the following statements is INCORRECT?

A) This is a covered strategy.
B) This is a hedged strategy.
C) This is a put writing strategy.
D) This is similar to a short put strategy.
E) This is an uncovered strategy.

Question 11

YBM has made an offer to buy Hot Products Inc.(HOP;a fictitious name)at $60 per share.The current price of HOP is $50.If the deal fails,HOP stock price will go down below $40 per share.Suppose you decide to obtain some trading profits by creating a straddle.You find that an call has a price of $4 and an put has a price of $3;both options have a strike price of $50 and expire in three months.If you set up a straddle,then you trade:

A) a long call and a short put
B) a long call and a long put
C) a short call and a long put
D) a short call and a short put
E) None of these answers are correct.

Question 12

To insure a stock,we generally combine:

A) a short call with a long stock
B) a long call with a long stock
C) a short put with a long stock
D) a long put with a long stock
E) a long futures with a long stock

Question 13

Suppose you have sold short YBM.To hedge this trade so as to "keep the upside" while "protecting the downside," you should add to your portfolio:

A) a short call on YBM
B) a long call on YBM
C) a long futures on YBM
D) a short futures on YBM
E) a long put on YBM

Question 14

Suppose you both short a call option and long a put option.Both these European options are on the same underlying stock and have the same strike price and expiration date.You have created a:

A) short forward
B) long forward
C) long option
D) long stock
E) None of these answers are correct.

Question 15

Which of the following statements is INCORRECT about the risks that an insurer faces?

A) Insurance businesses have been successful through the centuries because insurers are skillful in finding natural hedges.
B) Insurance companies employ actuaries who calculate the likelihood of loss events and fair premiums for insuring risks.
C) Actuaries cannot foretell whether any particular insured entity will suffer a loss,but they can estimate with reasonable accuracy the expected losses in a large population.
D) Insurers try to manage risks by diversifying their losses across a large number of policyholders with the hope that the law of large numbers holds.
E) Insurance companies often hedge their losses on catastrophic events by purchasing reinsurance.

Question 16

The price of a long position of a stock in your portfolio is $20.You decide to buy a put with a strike price of $17.50 worth $2 and sell a call with a strike price of $22.50 also worth $2.Then you have created:

A) a zero-cost collar
B) a bear spread
C) a covered call
D) a butterfly spread
E) a straddle