Stock Broker Options Trading & Strategies 2 — Questions and Answers
Question 1: A covered call strategy involves:
- Selling a call option while owning the underlying stock (Correct answer)
- Buying both a call and a put on the same stock
- Selling a call without holding any underlying shares
- Buying a call on a stock you plan to sell short
Correct answer: Selling a call option while owning the underlying stock
A covered call is when an investor who owns the underlying stock sells a call option against that position to generate additional premium income.
Question 2: What is the maximum profit for an investor who writes a covered call?
- Unlimited appreciation in the stock price
- The premium received plus any stock gains up to the strike price (Correct answer)
- The full intrinsic value of the call at expiration
- The premium received only, regardless of stock movement
Correct answer: The premium received plus any stock gains up to the strike price
The covered call writer's maximum profit equals the premium received plus any stock price appreciation from the purchase price up to the strike price.
Question 3: A protective put strategy is primarily used to:
- Generate income on an existing stock position
- Speculate on a declining stock
- Hedge against a drop in value of a stock you already own (Correct answer)
- Replace a stop-loss order at no cost
Correct answer: Hedge against a drop in value of a stock you already own
A protective put (buying a put on stock you own) establishes a floor price, limiting downside risk while preserving upside potential.
Question 4: What does 'out of the money' mean for a put option?
- The current stock price is below the strike price
- The current stock price is above the strike price (Correct answer)
- The option has reached its expiration date
- The option has been assigned to the writer
Correct answer: The current stock price is above the strike price
A put option is out of the money when the stock price is above the strike price, meaning exercising the put would be unprofitable and the option has no intrinsic value.
Question 5: An investor writes an uncovered (naked) call. What is their maximum potential loss?
- The premium received from writing the call
- The strike price minus the premium received
- The intrinsic value of the option at expiration
- Theoretically unlimited, as the stock price can rise indefinitely (Correct answer)
Correct answer: Theoretically unlimited, as the stock price can rise indefinitely
A naked call writer faces theoretically unlimited loss because there is no ceiling on how high the stock price can rise, yet they must deliver shares at the fixed strike price.
Question 6: What is the 'time value' component of an option's premium?
- The amount by which the option is in the money
- The strike price minus the current market price
- The portion of the premium that exceeds the option's intrinsic value (Correct answer)
- The number of trading days remaining until expiration
Correct answer: The portion of the premium that exceeds the option's intrinsic value
Time value is the portion of an option's premium above its intrinsic value, reflecting the probability that the option may gain additional value before expiration.
Question 7: How does time decay (theta) affect an option's time value as expiration approaches?
- Time value increases steadily as expiration approaches
- Time value decreases as expiration approaches, accelerating in the final weeks (Correct answer)
- Time value remains constant until the final trading day
- Time value converts entirely to intrinsic value at expiration
Correct answer: Time value decreases as expiration approaches, accelerating in the final weeks
Theta causes time value to erode as expiration nears, with the rate of decay accelerating significantly in the option's final weeks and days.
Stock Broker Options Trading & Strategies 2
A covered call strategy involves: