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6-1 CHAPTER 6: ADVANCED OPTION STRATEGIES END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. Simple long or short positions expose the trader to considerable risk. This is especially true for short positions. By taking an opposite position in another option, i.e., executing a spread, the trader is able to keep the risk to a more manageable level. Combined positions of options and stocks do the same thing-- the option serves as a hedge for the stock or the stock serves as a hedge for the option. However, a position in both options and stocks is harder to execute since the options and stock trade in different markets. This results in time delays in getting the trades executed. On the other hand, a spread can be executed much faster, with both transactions done almost simultaneously in the same market. 2. Since the stock price is closer to the higher exercise price than to the lower exercise price, the short call at the higher exercise price has the greater time value. Therefore, holding the position longer could result in a greater time value decay on the short call than on the long call. This will occur only, however, if the stock price does not move down. The cross-over point indicated in Figure 6.2 in the chapter is a critical stock price below which the shorter holding period is preferred. If it appears as if the stock price will fall below the cross-over stock price, the position should be closed as soon as possible, but only if the stock price is not expected to turn back around before the options expire. 3. Both a straddle and a time spread can be used in this situation. A straddle consisting of the purchase of a put and a call with identical exercise prices and expirations would profit if the stock price moved substantially in either direction. A time spread consisting of the sale of a longer-term option and the purchase of a shorter-term option would also profit if the stock price moved significantly in either direction. This is because a large stock price move will allow repurchase of the longer term option when it has little time value remaining. Note that this example is the opposite of the one discussed in the text. Also, a butterfly spread that is short the high and low exercise prices and long two of the middle exercise price could be used in this situation, but it would have limited gains if the stock price moved substantially. 4. A put bear spread could offer two advantages over a call bear spread. First, it is possible that the puts could be mispriced while the calls are correctly priced. Second, a call bear spread runs the risk of early exercise. The short call can be in-the-money without the long call also being in-the-money. For the put bear spread, however, the short put will not be in-the-money unless the long put is also. Then if the short put is exercised, the long put can be exercised for a net gain of -(E 1 - S t ) + (E 2 - S t ) = E 2 - E 1 which is the maximum value that could be expected by holding the position to expiration.
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This note was uploaded on 03/09/2011 for the course FINA 4210 taught by Professor Staff during the Fall '08 term at North Texas.

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