Answers to Options Quiz

The quiz was posted yesterday

Apparently there was a miscommunication. For some of these questions, there were multiple correct answers.

1) True or False:

Trading iron condors is almost free money. Just set it and forget it

False. Set it and forget is likely to result in losses over time. The iron condor strategy can be profitable when positions are well managed because the key to success is being certain that large losses are prevented.

Glad to report that everyone answered correctly

2) You have $50,000 in your trading account. As a speculation, you bought 20 Jul 70 call options. The stock has not performed as you hoped, but it has been moving higher all week and today (expiration Friday) opened for trading @ $69.80. Which of the following are true:

a) You own these options and thus, cannot be assigned an exercise notice. Nothing bad can happen to you.

Not true. If these options finish in the money, your account will be assigned an exercise notice automatically. You will be forced to buy 2,000 shares, or $140,000 worth of stock. Your account is far too small, and a margin call will be issued. You will be forced to sell these shares at the opening Monday, regardless of price.

25% thought this to be true. Owning the options does limit risk, but when it comes to owning them at expiration – danger looms.

b) You must do your best to sell the calls before the market closes for the day – just in case the stock closes above $70 per share

True. If there is no bid and you cannot sell, and if the stock is priced barely above the strike price when the market closes, notify your broker immediately: DO NOT EXERCISE

25% chose this. I expected a higher total.

c) It’s a good idea to enter a limit order to sell the options now. Then forget all about them
Not true. See reply to a) above.

13% voted for this choice. It’s seldom a good idea to forget about positions. This automatic exercise rule can result in big problems, even for those who own options.

d) It’s a good idea to enter a limit order to sell the options now. Then lower the asking price later in the day – as often as necessary
True. This is sound policy.

35% recognized that this is a decent choice. It may not be best, but that depends on how much time you have to follow the position during the day.

e) It is a reasonable plan to go for a bonanza by not looking at the stock or option price all day – until well after the market closes. Maybe you’ll get lucky and the stock will close @$72 – or higher.

Not true. Sure, you can go for the bonanza, but you MUST be certain to sell the options before the market closes for trading. You cannot afford to exercise these calls.

I’m pleased to see only one vote for this.

3) Out of the money put options on equities (stocks and indexes) tend to trade with a significantly higher implied volatility than do the out of the money call options. Which of these statemens is true.

a) This has been true since put options were first listed for trading at the CBOE
False. This phenomenon first appeared after the market crash of October 1987.

One vote

b) This observation is known as volatility skew True
50% of the votes

c) This observation is known as option kurtosis Not true
One vote

d) This is unreasonable, and this perplexing pricing will end soon Not true
No votes

e) This is true because huge and sudden declines occur more often than huge and sudden rallies True
The other 50% of the votes

I believe everyone would have voted for both had it been possible.

4) You are very excited about the prospects for a specific stock. You expect it to rise by 40% (from $40 to above $55) within two months, three at the most. You have had this feeling about other stocks in the past, and your track record is so-so. Six times the stock moved lower, but 4 times the stock moved nicely higher (but not as high as you anticipated).

Which of the following represent sound trades? Which trade suits you best? Which is the worst, in your opinion?

a) Buy three-month calls. Strike price $55
Worst possible choice in my opinion. Stock unlikely to move far enough quickly enough

One vote

b) Buy three month calls, strike price $50
Unsound. Almost as bad as a) above.
One vote

c) Buy two-month calls. Strike price $40 Sound choice most of the time. Best for traders who have confidence in their opinions. Three month is a bit safer.
Two votes

c) Sell two month puts; strike price $40 Sound choice, but risky
Two votes

d) Sell three-month, 35/40 put spread Sound choice
34% of the votes

e) Buy front-month 40/45 call spread Not a good choice. Time frame is too short
10% of the votes

f) Buy three month, 40/45 call spread Sound choice
40% of the vote

Best trade had votes spread over the whole map, but d) and f) had the most votes.

Buying three-month 55 calls was voted the worst trade. If you must buy OTM calls, at least buy one that you believe will be in the money eventually.

Thanks for participating

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