Chapter Three
Basic Option Strategies: Covered Calls and Protective Puts
Answers to Problems and Questions
1. Covering a call means either 1) buying back a call that you previously
wrote, or 2) adding a stock or long option position so that a short call is no
longer uncovered. A covered call is a short call in combination with a long
position in the underlying stock.
2. The maximum loss is known and limited with a long put, while the
maximum loss is unlimited with a short sale. The maximum possible profit
is similar for the two strategies.
3. A perpetual European option could never be exercised, and consequently
has no value. A perpetual American option would have value.
4. If prices decline sharply, put overwriting causes the portfolio to lose twice,
once from the decline in the underlying asset and again from the puts going
in-the-money.
5. Protective puts serve the same function as insurance. They reduce risk, and
there is often a benefit to doing so.
6. Those who employ protective puts typically select a striking price that is
out-of-the-money. How far out of the money is a function of individual
preference.
7. With a covered call the most common version involves an out-of-themoney option, although this need not be the case.
8. Someone with a short position in the stock could hedge against price
increases by buying a call. An outright purchase of a call is a speculation.
9. The consequences of exercise differ. If you write calls and they are
exercised, you will have to buy stock to transfer to the call holder. This
would involve a loss to you. If you write puts, the shares you receive can
be used to close out the short position with no further loss.
10. Assuming a covered put means the combination of a short stock position
and a short put, both the covered call and the covered put experience a loss
if prices rise. With the covered call, however, the loss is an opportunity
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Chapter Three. Basic Option Strategies
loss in that the aggregate gain would have been larger had the call option
not been written.
11. If you sold the put for more than you paid for it you would have a profit on
the trade.
12. Buying puts provides much better downside protection than writing
covered calls. With a covered call, the protection is limited to the premium
received, but it begins immediately. With a put, there is dollar for dollar
protection, but it does not begin until the put goes in-the-money.
13. An in-the-money put will likely be exercised if prices remain unchanged.
14. The positions are different. There are two bends in the profit and loss
diagram if you write options with more than one striking price.
15. We assume that money could always earn interest. Because of this, if you
buy stock at one price and later sell it for the same price, you did not really
break even because of the opportunity costs.
16. No. This does not provide free money. Writing options alters the
probability distribution of returns and the premium reflects this change in
possible outcomes.
17.
8½
76 ½
85
76 ½
18. Stock: 400 x ($74 – 79 7/16) = -$2,175
Options: 2 x 100 x (5 7/8 – 6) = - $25
Total =
$2,200 loss
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Chapter Three. Basic Option Strategies
19.
7 9/16
72 7/16
80
72 7/16
20. Asking an after-the-fact question on whether the acquisition of insurance
was a good idea is not useful. In this case, the puts expire unexercised, so
the insurance was not used. This does not mean it was not a good idea.
21.
21 9/16
90
79 7/32
158 7/16
22. This is the combination of a long position in stock and a put bullspread, as
Chapter four will illustrate. The position becomes very profitable if the
stock price rises above 90.
23. Stock: no gain
Long 75 put: expires out of the money  loss of 3 5/8
Short 90 put: gain = 12 1/8 – (90 – 79 7/16) = 1 9/16
Net result = 2 1/16 loss
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Chapter Three. Basic Option Strategies
24.
7/16
90 7/16
90
This is similar to writing a naked call.
25.
1 13/16
75
73 3/16
73 3/16
26.
Stock: 300 x (72 – 79 7/16) = -$2,231.25
Put: 100 x (2 3/16 – 0) =
$218.75
Net loss =
-$2,012.50
27.
7 13/16
77 3/16
85
77 3/16
9