I decided to try something unusual today.  A pop quiz.  And you can grade yourselves.  Please don't comment with answers before Tuesday.  If you have comments or require additional details, then, by all means, post a comment.

This material is intended to see if you really understand how options work.  Although intended for those without a great deal of experience trading options,  it may be challenging even for seasoned traders, depending on a variety of circumstances.

Answers Tuesday morning.

1) You bought 10 XYZ Dec 50 calls and 10 XYZ Dec 50 puts.  Two weeks later XYZ released very bad news, and the stock plunged from 48 to 30. 

You lost money on this trade.  How is this possible?

2) You bought five OTM (out of the money) call options.  As soon as the stock moved past the strike price of your calls, you exercised those call options and sold your stock.  The next day when you looked at the profit/loss numbers on your confirmation statement (a list of trades) you were horrified to discover that you lost money on this trade.

You were under the impression that an increase in the stock price was a good thing.  Why did you lose money?

3)  You own 400 shares of ZZY.  You decided to write covered calls and sold four Jan 65 calls, collecting $350 for each.

When January expiration arrived, you were assigned an exercise notice on all four of those call options.

When deciding whether you are going to write another four covered call options for February, what is your primary consideration?

  • Is it the stock price?
  • Is it the price of the Feb 65 calls?
  • Is it the price of the Feb 70 calls?
  • Is it something else?

4)  You own 1,000 shares of stock and wrote five covered calls.  The stock has rallied, and those calls are now 15 points in the money.  You sold 500 shares, and you would prefer to be assigned an exercise notice so that you can get your cash and reinvest that money in an other position.

What is the process by which you can demand that the owner of the call options exercise them?

5)  You want to buy some put options but have a major concern.  If the underlying stock drops sharply – as you are confident it will – you are afraid to take the chance that (if you exercise the options) the person who sold those put options may default, and be unable to afford to buy the stock at the strike price.  That would leave you with no way to exercise your options.

Is this a reasonable concern?


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