Question 1

A rising price for the contract item will lead to rising losses for the holder of a short position in a put option.

Accepted Answer

A short position in a put option establishes the obligation to buy the contract item at a fixed price (the strike price). Therefore, if the price for the contract item rises, the holder of the put option is not affected because they can simply choose not to exercise the option. It is the writer/seller of the put option who will potentially experience losses as the price of the contract item rises, since they are obligated to buy it at the strike price.

Question 2

A lender can use an interest rate option to secure a floor on its lending rate but forgoes any benefit from a rise in future lending rates.

Accepted Answer

An interest rate floor allows a lender to secure a minimum interest rate on its lending, but it does not forgo the benefit from a rise in future lending rates. Instead, it ensures the lender receives at least the floor rate, while still benefiting if rates rise above the floor.

Question 3

A bull spread is a combination of a long call with a low exercise price and a short call with a high exercise price.

Accepted Answer

A bull spread involves buying a call option with a lower exercise price and selling a call option with a higher exercise price, with the goal of profiting from a rise in the underlying asset's price.

Question 4

The holder of an in-the-money option that has one month to expiry would prefer to close out the position on the ASX market, rather than exercise the option.

Accepted Answer

Closing out the position on the ASX market allows the holder to lock in their profits or limit their losses without having to go through the additional steps and costs of exercising the option.

Question 5

Consider the $13.50 and $13.00 May Swans Inc.calls that are trading at 7 and 13 cents, when the share price is $12.34.The $13.00 call is a better buy, as it is only 6 cents more expensive whereas its exercise price is 50 cents lower.

Accepted Answer

The $13.00 call is not necessarily a better buy just because it is cheaper and has a lower exercise price. The value of an option also depends on other factors such as time to expiration, implied volatility, and the likelihood of the stock price exceeding the strike price.

Question 6

It makes sense for traders expecting a stagnant market with low levels of volatility to take a short straddle position with exercise prices close to the current asset price.

Accepted Answer

A short straddle position involves selling both a call option and a put option with the same exercise price and expiration date. This is a good strategy for traders when they believe the market will remain relatively stagnant with low levels of volatility. By choosing an exercise price close to the current asset price, they increase the likelihood that neither option will be exercised, allowing them to profit from the premium collected from selling the options.

Question 7

The value of an option moves on a dollar-for-dollar basis with the price of the underlying asset.

Accepted Answer

The value of an option does not move on a dollar-for-dollar basis with the price of the underlying asset due to the option's delta, which measures the rate of change of the option price with respect to changes in the underlying asset's price. Delta values range between 0 and 1 for calls (0 and -1 for puts), indicating that the option's price moves only a fraction of the underlying asset's price movement.

Question 8

A bull spread is a more aggressive (high risk/high return)option position than buying a call.

Accepted Answer

A bull spread involves both buying a call option and selling a call option with a higher strike price. This limits potential profit, but also limits potential losses compared to just buying a call option. Therefore, a bull spread is typically considered a less aggressive (lower risk/lower return) option position than buying a call.

Question 9

An option trader will acquire a long straddle if the trader expects a share price to become much more volatile than the market expects.

Accepted Answer

A long straddle involves buying both a call option and a put option at the same strike price and expiration date. This strategy profits if the underlying security experiences a large price movement, either up or down, beyond the cost of the premiums paid for the options. Therefore, an option trader may use a long straddle if they have a strong belief that a particular stock or index will experience more volatility than the market is currently anticipating.

Question 10

Long put positions are taken by speculative traders who expect the put's price (its premium)to fall.

Accepted Answer

Long put positions are taken by speculative traders who expect the underlying asset's price to fall, not the put's price (premium). The put's premium may increase if the underlying asset's price falls, leading to a profit for the trader.

Question 11

Option strategies are formed by combining option positions or combining an option position with a position in the underlying asset.

Accepted Answer

Option strategies can be created by combining multiple option positions or combining an option position with a position in the underlying asset.

Question 12

An interest rate cap can be established by buying put options on successive BAB futures contracts.

Accepted Answer

By buying put options on BAB futures contracts, the buyer has the right to sell the underlying asset (BAB futures contract) at a predetermined price (strike price) before the option expires. This provides protection against interest rate increases, as the put option will become more valuable as the underlying asset (BAB futures contract) decreases in price due to rising interest rates. Therefore, buying put options on successive BAB futures contracts can establish an interest rate cap.

Question 13

Traders expecting an increase in price volatility of the underlying share will consider a short straddle, while long straddles may be used by those expecting a decrease in volatility.

Accepted Answer

A long straddle is used by traders expecting an increase in price volatility, as it involves buying both a call and a put option with the same strike price and expiration date. A short straddle, on the other hand, is used by traders expecting a decrease in volatility, as it involves selling a call and a put option, betting that prices will remain stable.

Question 14

The Black-Scholes is the best known option-pricing formula.

Accepted Answer

The Black-Scholes model is one of the most widely used and famous option-pricing formulae.

Question 15

Selling an option is equivalent to selling volatility in the underlying asset.

Accepted Answer

Selling an option involves selling the right to buy or sell the underlying asset at a certain price, which can be seen as selling volatility in the price of the underlying asset. As the price of the underlying asset becomes more volatile, the value of the option increases, making it more expensive to buy. Therefore, selling an option is equivalent to selling volatility in the underlying asset.

Question 16

Put options allow investors to make profits when share prices are falling.

Accepted Answer

Put options give the owner the right, but not the obligation, to sell a stock at a predetermined price (strike price) within a specified period of time. If the share price falls below the strike price, the owner of the put option could buy shares at the lower market price and sell them at the higher strike price, making a profit on the difference. Therefore, put options allow investors to make profits when share prices are falling.

Question 17

The holder of an 'out-of-the-money' call option will not necessarily benefit from a rise in the underlying asset's share price.

Accepted Answer

An 'out-of-the-money' call option means the strike price is higher than the current market price of the underlying asset. Therefore, the option holder will not benefit from a rise in the share price unless it rises substantially above the strike price, making the option 'in-the-money.'

Question 18

Options can be profitable even when share prices are stable.

Accepted Answer

Options such as straddles and strangles can be profitable even when share prices are stable. These strategies involve buying both a call option and a put option with the same expiration date and strike price, allowing investors to profit from any significant price movement in either direction.

Question 19

When an option is exercised the time value component is lost.

Accepted Answer

When an option is exercised, the owner of the option is exercising their right to buy or sell the underlying asset at the strike price. This means that the option's time value, which represents the uncertainty of the option's future value, is no longer relevant and is lost.

Question 20

A buy-and-write strategy is equivalent to a short put on the asset.

Accepted Answer

A buy-and-write strategy involves purchasing an asset and simultaneously writing call options on that same asset. This is similar to a short put position, as the seller of a put option has the obligation to purchase the underlying asset at the strike price if the buyer decides to exercise their option. Therefore, a buy-and-write strategy can be seen as a short put position in terms of the overall risk and reward.

Quiz 15: Exchange-Traded Options