Options Trading Strategy Test 1 — Questions and Answers
Question 1: The maximum return on investment for equity option contracts is :
- Unlimited
- Premium received
- As per investment
- Limited (Correct answer)
Correct answer: Limited
For an option seller (writer), the maximum return is always limited to the premium received when selling the contract. While a call option buyer's potential return is theoretically unlimited, the question refers to 'equity option contracts' generally. Given 'Limited' is the correct answer, it likely emphasizes the limited profit potential for sellers or the limited upside for put option buyers.
Question 2: What impact does a market-to-market contract have?
- The agreement is reverted.
- The underlying asset is delivered. (Correct answer)
- One of the contract's sides breaches the agreement.
- Prices changes in the underlying market are reflected in the contract holder's margin account.
Correct answer: The underlying asset is delivered.
Mark-to-market is an accounting method that values assets and liabilities at their current market price, leading to daily adjustments in a contract holder's margin account to reflect profits or losses. This process ensures that gains and losses are settled regularly, preventing large accumulated debts. The delivery of the underlying asset, as stated in the provided answer, is a settlement mechanism at expiration or exercise, not the direct impact of market-to-market accounting.
Question 3: What is the intrinsic value of a put option that is in the money?
- Zero.
- The stock price less the exercise price.
- The value of a share less the cost of an exercise. (Correct answer)
- A premium for puts.
Correct answer: The value of a share less the cost of an exercise.
The intrinsic value of an In-the-Money (ITM) put option is calculated as the Strike Price minus the Current Stock Price, representing the immediate profit if exercised. For a put to be ITM, its strike price must be higher than the current stock price. The provided answer, 'The value of a share less the cost of an exercise,' is ambiguous but, if interpreted as (Current Stock Price - Strike Price), would describe the intrinsic value of an ITM *call* option, not a put.
Question 4: What is the crucial connection between a futures markets and an observer?
- The futures price and the underlying instrument's cash price in the future at the delivery location stated in the futures contract.
- The underlying instrument's present value and its future value at the delivery location stated in the contract.
- The cost of retaining the underlying asset from the time of purchase till delivery, as well as its price. (Correct answer)
- The cost of keeping the underlying asset from the time of purchase to delivery, as well as the futures price.
Correct answer: The cost of retaining the underlying asset from the time of purchase till delivery, as well as its price.
The crucial connection between futures prices and the underlying asset's spot price is largely explained by the 'cost of carry.' This refers to the expenses incurred for holding the underlying asset from the present until the futures contract's delivery date, including storage, insurance, and financing costs, minus any income generated. The futures price is essentially the spot price plus this cost of retaining the asset.
Question 5: The identical strike prices are quoted for a stock's three Call series, which are for May, June, and July. Which option premium will be the highest?
- July (Correct answer)
- June
- May
- All will be on an equal footing
Correct answer: July
Option premiums are influenced by several factors, including the time remaining until expiration. All else being equal (identical strike prices, same underlying asset), an option with a longer time to expiration will have a higher premium due to greater time value. More time allows for a higher probability of the underlying asset's price moving favorably and for the option to become in-the-money, making the July option the most expensive.
Question 6: Another name for "squaring off" is :
- Opening a position
- Closing a position
- Leverage (Correct answer)
- None of the options are correct
Correct answer: Leverage
The term 'squaring off' in options trading, or any financial market, refers to closing an existing position to realize a profit or loss. This involves taking an opposite trade to the initial one, such as buying back an option that was initially sold. Leverage, on the other hand, is the use of borrowed capital to increase potential returns, which is a different concept entirely. Therefore, 'Closing a position' is the accurate term for squaring off, making 'Leverage' an incorrect answer in this context.
Question 7: What is the measurement of the option value's sensitivity to a specific tiny change in the underlying asset's price?
- Theta (Correct answer)
- Gamma
- Chi
- Sigma
Correct answer: Theta
The measurement of an option's value sensitivity to a tiny change in the underlying asset's price is known as Delta. Theta measures the sensitivity to the passage of time (time decay), Gamma measures the rate of change of Delta, and Sigma (or Vega) measures sensitivity to volatility. Therefore, Theta is incorrect for the given definition, which describes Delta.
Options Trading Strategy Test 1
The maximum return on investment for equity option contracts is :