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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

992
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Options quiz

I haven’t run a quiz in a long time, so let’s try another.



For your convenience, the questions are repeated below.
However, you must click on the button to have your reply tallied

1) True or False:

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

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

    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

    c) You should enter a limit order to sell the options now. Then forget all about them

    d) You should enter a limit order to sell the options now. Then lower the asking price later in the day – as often as necessary

    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.


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 statement is true.

    a) This has been true since put options were first listed for trading at the CBOE

    b) This observation is known as volatility skew

    c) This observation is known as option kurtosis

    d) This is unreasonable, and this perplexing pricing will end soon

    e) This is true because huge and sudden declines occur more often than huge and sudden rallies


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 follow represent sound trades? Which trade suits you? Which is the worst, in your opinion?

    a) Buy three-month calls. Strike price $55

    b) Buy three month calls, strike price $50

    c) Buy two-month calls. Strike price $40

    c) Sell two month puts; strike price $40

    d) Sell three-month, 35/40 put spread

    e) Buy front-month 40/45 call spread

    f) Buy three month, 40/45 call spread

Answers tomorrow

991
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Quiz Answers

Thanks to everyone who participated in Friday's quiz.  I learned some lessons by offering this quiz.

The first is that these polls do not appear on an RSS feed.  For that I apologize.  If anyone has a solution to that problem, I'd appreciate hearing about it.

 

The answers

1) Which of these is the main difference between writing 5 AAPL Dec 280 covered calls and selling 5 AAPL Dec 280 puts?

c) Commissions are higher for the covered call

It's true that the trades are equivalent and it makes no difference which you own.  However, transaction costs are not considered when positions are compared.  Writing covered calls requires payment of two commissions, vs. one for the put sale.  For traders who have tiny commissions, this difference is unimportant.

The trap on this question is the fallacy that selling naked puts is far more dangerous.  Writing covered calls is no different from writing a naked put.  The profit/loss profiles are identical – when the strike price and expiration date of the put and call are also identical.

The fact that so many (17%) chose the 'dangerous' put as their answer suggests that  some basic topics for option rookies are worth revisiting.  This specific misconception should be addressed early in a trader's career.  Look for more on this topic tomorrow

 ***

2) You feel XYZ (no dividends) is headed lower. Which trade is better:

i) Sell Jan 90/95C spread; collect $2 premium

ii) Buy Jan 90/95P spread; pay $3 premium

d)* they are equivalent and it makes no difference

However, in all fairness I want to point out that it is better to collect $300 cash than to pay $200 for the equivalent position.  With interest rates so low, today the answer is that it makes no difference.  But be aware that when interest rates are higher, it's better to collect interest on $300 than to pay it on $200.

*Thus, if you chose 'Sell the call spread' for the reason stated above, consider that to be the correct answer.

The price of XYZ makes no difference.  The two spreads have identical financial outcomes when expiration arrives.  Each can earn a maximum profit of $200 and incur a maximum loss of $300.

For anyone who wants to look more deeply into a detail of the trade, it is better to sell the call spead for this reason:  If you are correct and the stock does decline, the calls expire worthless and the puts expire in the money.  Most brokers get away with charging a fee (and a relatively steep one) for each exercise or assignment.  Thus, selling the call spread avoids paying those two fees – when you are correct in your prognostication.

 ***

3) Rank them in order: most profitable to largest loss

b,a,c,d

Once I amended the question requesting that you enter the correct sequence as 'other' 2/3 of responders had the correct answer.

b) is the most profitable because time passes and nothing happens

a) is next.  It's basically the same situation as b).  The difference is that implied volatility has increased – and that results is less profit for the iron condor trader

c) The 40-point decline is not good, but it is not as bad as

d) the 100 -point rally.  The short call option is now 30 points in the money

***

4) Which of the following offers the best alternative for the majority of individual investors?

The two options related answers garnered 80% of the votes.  And those are the two best answers to the question.

c) Sell the entire portfolio and replace each 100 shares of stock with an in the money (delta 70) call option

More than twice as many voters chose d), rather than c).  An explanation is in order.

Buying the puts is straightforward.  The trader maintains possession of his/her portfolio and protects the downside by owning a put option.  However, owing 100 shares of stock and one put option is equivalent to owning one call option at the same strike.  Thus the buyer of an at the money protective put is, in reality, changing the portfolio from long stock to long ATM calls.

Alternative c) also finds the investor owning an all-call portfolio.  The difference is that this time the call is ITM.  The downside is protected because all that can be lost is the value of the call.

c) gives the investor a better opportunity to earn money on a continued rally because he/she owns the 70 delta call instead of the 50 delta (synthetic) call.   

d) affords better downside protection, but costs more.  The other play (c) is equivalent to buying the 30 detla put, and that is less expensive than buying the ~50 delta, at the money, put.

On re-reading this reply, it seems that I am imposing my comfort zone boundaries on this answer.  Obviously if you prefer to own the 50-delta synthetic call than the 70-delta call, how can I judge that it's the 'wrong' answer?

But please be aware that the cost is higher and that the upside is not as good.

Selling part of your portfolio is reasonable, but the real question is:  how much to sell? 

***

5)  In your opinion, which two of the following played the most important role in determining your past success as an option trader?

The top vote getters (the poll is still open) had nothing to do with the actual trading.  Instead they were all factors that concerned risk management:

1) Preventing large losses (32%)

2) Following a trade plan (19%)

3) Not trading too much size (23%)

That's a very pleasing result.  Market timing and predicting direction may be something that some traders can do well, but your responses tell me that you not only understand the importance of good risk management, but that you practice it and it pays off in extra income.

Thank you for participating

807

Learned a great deal from your book.  This is especially true regarding Equivalent Positions.  Your chapter was the clearest explanation that I have ever read.  Thank you for making the effort to put out such a fine book." DS

 

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Quiz

It’s been almost one year since I last published an options quiz.  Time for another. 

Your participation is appreciated becasue it helps me gauge which material is most appropriate for readers of Options for Rookies

 

1)

 

2)

 

 

 

3) You decide to trade some Weeklys and open an iron condor position by selling an out of the money SPX put spread (1100/1110) and an out of the money SPX call spread (1220/1230).  All options expire in one week.  SPX is trading at 1160. [Corrected to 1160]

By Tuesday of expiration week, ONE of the following events occurred:

To reply, choose ‘other’ and enter (for example) a,b,c,d

 

4) Let’s assume you have been bullish and earned a significant profit on your investment portfolio since May 2010. You are concerned with protecting your profits. 

Please consider cost, how much protection is gained, and the possibility of earning a lot more money if the market undergoes another major rally


 

 

5)  Poll: This question is directed to you as a trader/investor.  I am not looking for a theoretical reply, but am asking which of the following worked for you. 

 

 

Thanks for participating

806

“Your book is well written, comprehensible, coherent and detailed.  I was especially pleased with the absence of useless chatter.”  VT 

 


 

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Answers to Options Quiz

80 Year Anniversary

1929 crash

ADDENDUM:  I've been told that the links to the poll results (they were below, but have been removed) are not functional.   Please go to the quiz and click on 'view results' at the bottom of each poll question.  Sorry for the inconvenience.

If you missed it, the quiz was posted yesterday.

1) What can you do to collect those dividends?

I'm pleased to see that the vast majority of readers answered this correctly.  There is nothing you can do to get the dividends.  Your broker cannot reverse the assignment – because assignments are final.

If you buy new shares, it's too late to collect the dividend.

2) That put spread you sold – is it a winner or loser?  The stock declined 5 points and there's plenty of time remaining before expiration.  This spread is clearly a loser.

Many of you thought much more information is needed to determine the answer.  While it is true that if the implied volatility dropped all the way to zero, the spread would be a winner.  But that is never going to happen and you have all the information needed to believe that the spread seller is currently losing cash on the position.

3) What happens to the options? The calls expired out of the money and thus, expire worthless.

But, the option owner is allowed to exercise.  That might occur if the option owner was short shares and unable to cover that short at his/her bid price.  Exercising the calls and paying $30 per share eliminates all risk.

Thus, the correct answer is e): 'both b) and c) are correct'

4) This is an opinion question, and thus, no 'correct' reply.  But some choices are far better than others.  Which adjustment trade would you prefer an iron condor:

a) Sell five put spreads.  Collect some cash.

This is a poor choice and few chose it.  There are two major problems.  First it does not provide enough cash to do much good if the market rallies farther. Second, if the market reverses, you can quickly get in trouble with the new put spread.  This is a high risk/small reward play.

b) Buy 3 Nov 720 calls. 

These are too far OTM to help.  Yes, they are great if the market quickly undergoes a huge rally, but that is unlikely and as time passes, these calls provide less and less protection.

c) Cover 20% of the short spread position.

This is a good idea.  It reduces risk and keeps you in the game.  The only time this is not a good choice is when you hate the position and want to cover the entire short position.

d) Buy one Nov 680 call. 

I like this idea.  Owning one or more extra long options provides excellent protection against a large move.  It's not cheap, but provides extra chances to earn a profit.  Unlike OTM calls, it's always valuable if and when your short strike is threatened.

e) Convert to double diagonal. 

Too expensive for me.  There would be a profit on the adjustment if the stock rallies, but those profits are limited and are not nearly enough to offset losses from the original iron condor.

If you fail to sell the calendar spread when it's near the strike price, then a further rally results in losses on both the IC and the calendar.  In other words, this doesn't help on a good-sized rally – and that's your biggest risk right now.

In addition, the double diagonal is vega rich and a rally will probably result in a continued IV decrease – further hurting the calendar spread.

My preferred answer:

Either c) or d) works for me. 

I don't like the other choices, but b), e), and last is a).

495

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Options Quiz

It's time for another quiz.

Rookie Section

1) It's two weeks before expiration and you own a covered call position: Long 400 shares of XZY and short 4 Jun 30 calls.  The stock is trading at $34 per share.

When you look at your statement the next morning you notice that you have been assigned an exercise notice on your 4 calls and that you no longer own a position in XZY shares.  You are disappointed because the stock went ex-dividend this morning, paying $0.42 per share.  You wanted those dividends.


2) You sold your first credit spread by buying ZZX Nov 45 puts and selling an equal number of ZZX Nov 50 puts.  The stock is currently trading at $54 per share and expiration arrives in 35 days.

One week later, ZZX is trading at $49.



3) An investor owns 3 Feb 20 calls. The closing price for the underlying stock on expiration Friday is $19.99.

Non-Rookie Section

You own a 5-lot position of QZZ Nov iron condors.  The call portion is the QZZ Nov 690/700 spread.  Although you were quite comfortable with that call position when you made the trade, with only three weeks remaining before the options expire, QZZ has rallied to 675, and you are ready for a Stage I adjustment.

Assume that your adjustment choices are limited to the five listed below.

Assume this is your last trade and that you will hold the position through expiration.  These assumptions violate my trading philosophy, but this is a quiz based on a given set of circumstances.

a) Sell 5 QZZ Nov 630/620 put spreads; collecting $0.90 for each.  The $450 cash will cushion any upside losses.

b) Buy 3 QZZ Nov 720 calls.

c) Buy to cover, 20% of your current position, or 1 QZZ Nov 690/700 call spread

d) Buy one QZZ Nov 680 call.

e) Buy 5 QZZ Dec/Nov 700 call spreads, thereby converting the position into a double diagonal spread.  Cost $5 ($500 cash) per spread.



Answers tomorrow

494

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Options Education. Quiz answers. Commentary

Mark,


How about sharing the results of your quiz, i.e. Number responded and
% for each answer? I'd like to see how I did compared to you other
readers.

Tom

***

Addendum: Thank you for responding to tell me that the results do not accurately count your responses.  I sent a complaint/questions to MicroPoll to determine the source of the problem. A bit of dabbling on my part shows that some of the data has been lost.  I'll choose a better polling web site next time.


Good idea Tom. There were an average of 55 replies to each question.  I recognize that most readers don't bother to reply, but I find it very disappointing that 100% of readers who did reply had the incorrect reply to two questions.

I must assume that readers who are option rookies responded and others did not.  But as a blogger whose mission it is to help prepare readers for trading options with real money, I'm wondering if more posts containing very basic information are necessary. Please comment.  I do want this blog to contain the information you want to read.

1) Like quizzes?

2% never
44% yes
54% once in awhile

2) Options expired worthless: 100%  Incorrect polling result


3) I'm out of luck: 100%  Incorrect polling result



4) Which call to buy

Aug 30 calls: 29%
Aug 40 calls: 2%
Aug 45 calls: 49%
Aug 50 calls: 20%


I must admit I'm surprised.  So many people are anxious to get started that they bypass a solid education (that's why I'm writing this blog), but it's necessary to understand the basics of how things work.

I consider this quiz to be a success because it demonstrates that nothing should be taken for granted.  I'll be certain to include information that every option trader needs to know. 

This situation may be a failure of the broker – by not exposing each trader to the basics, or if the rookie, who is often so anxious to get started that he/she cannot be bothered with the details.

426

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Options Education. Quiz Answers

Answers to yesterday's quiz

1) You were assigned, and now own 500 shares.

When an option finishes in the money by any amount, the option is automatically exercised. (An absurdity in my opinion).

The only way you can prevent being assigned an exercise notice is to sell the option or notify your broker (immediately after the close on expiration Friday) that you DO NOT want to exercise an option that is in the money.2) Congratulations.  You have $40,000 in your account.You needed worry about the person from whom you bought the options.  Your relationship with the seller is severed immediately after the trade takes place.  The Options Clearing Corporation (OCC) steps in and guarantees that the contract will be honored.Things being as they are today, it's worth mentioning that the OCC has never (36+ years) allowed an option go into default.

2) Updated;  now includes answer #2

You have $40,000 in your account.

The OCC (options Clearing Corporation) guarantees that all option contracts are honored.  When you buy or sell an option, you are immediately separated from the specific individual with whom the trade was executed.

The OCC takes over and acts as the buyer and seller of each trade to guarantee that there is never a default.  You can rest assured that any trade you made will be honored.

If that other person has gone broke, it's up to his/her broker to try to recover the money from that specific trader.  You, the person on the other side of the trade, are 100% protected.

3) Buy 25 Aug 45 calls.  At expiration, they are worth $500 apiece, or $12,500.

Five Aug 30 calls are worth $2,000 per, or $10k

11 Aug 35 calls are worth $1,000each, or $11k

The Aug 50 calls are worthless.  But, if you were aware that they could have been worth a significant amount – depending on how rapidly the stock price increases, that's good.  It's possible that these were the calls to buy. 

Because you don't know if the option price ever moved high enough to generate a good profit, the 'correct' answer is 'Aug 45 calls.'  Buying the Aug 50 calls is not 'wrong' – it's just a big gamble.  Why do than when you get turn your dream into a guaranteed $11,500 profit?

***

I frequently receive junk e-mail from The Book of the Month Club.  The subject is always: "the best option for book-lovers'

I'm always hoping to see a slight change: "the best option book for book-lovers: The Rookie's Guide to Options"

425



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