Question 1

A covered call is constructed by buying the stock and selling the call.

Accepted Answer

A covered call strategy involves owning the underlying stock and then selling a call option on that same stock. This means you are providing someone else the right to buy your stock at a certain price within a certain time frame, while you collect the premium from selling the call option.

Question 2

Holders of calls do not receive the cash dividends paid to the company's stockholders.

Accepted Answer

Call option holders are not entitled to dividends paid on the underlying stock since they do not actually own the stock, but rather the option to buy it.

Question 3

If the price of an option to buy stock were to sell for less than its strike price, an opportunity for arbitrage exists.

Accepted Answer

The price of an option (premium) is not directly compared to its strike price for arbitrage opportunities. Arbitrage involves exploiting price differences of the same asset across different markets or forms. The option's price is determined by factors like the underlying stock's price, volatility, time to expiration, and the strike price, not just the strike price alone.

Question 4

Investors and speculators rarely, if ever, have an opportunity to establish an arbitrage position.

Accepted Answer

Arbitrage positions are rare because they require the simultaneous purchase and sale of the same asset at different prices, which is difficult to achieve in practice.

Question 5

Because of the small cash outlay to buy an option, these securities are considered to be conservative investments.

Accepted Answer

Options are not considered conservative investments because they are highly speculative and can result in significant losses, much more than the initial small cash outlay.

Question 6

Calls are options to sell stock at a specified price within a specified time period.

Accepted Answer

Calls are options to buy stock at a specified price within a specified time period.

Question 7

The intrinsic value of an option to buy stock (i.e., a call option)is the difference between the price of the stock and the per share exercise price of the option.

Accepted Answer

The intrinsic value of a call option is calculated by taking the difference between the current price of the stock and the strike price of the option, but only when the stock price is above the strike price. If the stock price is below the strike price, the intrinsic value is considered to be zero, as the option would not be exercised profitably.

Question 8

The time period to expiration for call options is usually less than a year.

Accepted Answer

Most call options traded on exchanges have expiration times ranging from a few weeks to several months, typically less than a year, although longer-term options (LEAPS) can extend beyond a year.

Question 9

The time premium paid for an option reduces the option's potential leverage.

Accepted Answer

The time premium is the amount paid over the intrinsic value of the option, which decreases as the expiration date approaches, reducing the leverage effect since more capital is required for an investment that may yield less return as time erodes the premium.

Question 10

Since options offer potential leverage, they tend to sell for a time premium.

Accepted Answer

Options often sell for a time premium because the value of the option includes not just the intrinsic value (if any) but also the potential for the underlying asset to move in a favorable direction before expiration, offering leverage to the buyer.

Question 11

Arbitrage is the act of simultaneously buying and selling in two markets to take advantage of price differentials.

Accepted Answer

Arbitrage involves buying and selling the same asset in different markets at the same time to profit from price differences between those markets.

Question 12

Arbitrage determines the maximum price of an option.

Accepted Answer

Arbitrage involves exploiting price differences of the same asset in different markets or forms, but it does not determine the maximum price of an option. Option pricing is influenced by factors such as the underlying asset's price, volatility, time to expiration, and interest rates, typically modeled using techniques like the Black-Scholes formula.

Question 13

As the price of a stock rises, the time premium paid for an option to buy stock increases.

Accepted Answer

As the price of a stock rises, the time premium paid for an option to buy stock decreases.

Question 14

The price of an option is generally less than the option's intrinsic value.

Accepted Answer

The price of an option (its premium) can be equal to or greater than its intrinsic value because it also includes time value, which accounts for the potential of the option to gain in value before expiration.

Question 15

The strike price of an option is fixed when the option is issued.

Accepted Answer

The strike price, also known as the exercise price, is determined at the time the option contract is issued and remains fixed for the duration of the option contract.

Question 16

Call options, unlike warrants, may be written by individuals.

Accepted Answer

Call options can be written (created) by individuals as part of the options market, whereas warrants are typically issued by companies, giving the holder the right to purchase the company's stock at a specific price before expiration.

Question 17

The maximum potential profit on a covered call is the time premium paid for the stock.

Accepted Answer

The maximum potential profit on a covered call is achieved when the stock price rises to or above the strike price of the call option sold. It is the sum of the premium received for selling the call and the gain in the stock price up to the strike price, not just the time premium paid for the stock.

Question 18

An option's intrinsic value exceeds the option's price.

Accepted Answer

An option's intrinsic value is the part of the option's price that can be realized if the option is exercised immediately. It does not exceed the option's total price, which also includes time value and possibly other components.

Question 19

A warrant is an option issued by a corporation to buy its stock at a specified price within a specified time period.

Accepted Answer

A warrant is indeed a financial instrument issued by a corporation that gives the holder the right, but not the obligation, to buy the company's stock at a specified price within a specified time period.

Question 20

Because of arbitrage, an option should not sell for less than its intrinsic value.

Accepted Answer

Arbitrage opportunities arise when an option is selling for less than its intrinsic value, allowing traders to buy the option and immediately exercise it for a risk-free profit, thus options should not sell for less than their intrinsic value in efficient markets.

Quiz 17: An Introduction to Options