010 - 10 The Options Market Answers to Questions and...

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65 Answers to Questions and Problems 1. State the difference between a call and a put option. Call and put options are the two fundamental kinds of exchange traded options. They differ in the rights and privileges that ownership conveys. The owner of a call option has the right to buy the good that underlies the option at a specified price, with this right lasting until a stated expiration date. The put owner has the right to sell the good that underlies the option at a specified price with this right lasting until a stated expiration date. Thus, owning a call gives the right to buy and owning a put gives the right to sell. Correlatively, the seller of a call receives a payment and must sell the underlying good at the option of the call owner. The seller of a put receives a payment and must buy the underlying good at the option of the put owner. 2. How does a trader initiate a long call position, and what rights and obligations does such a position involve? To initiate a long call position, a trader buys a call option. At the time of purchase, the trader must pay the price of the option, which the seller of the call collects. Upon purchase, the owner of a call has the right to purchase the underlying good at the specified call price with that right lasting until the stated expiration date. The owner of a call has no obligations, once he or she pays the purchase price. 3. Can buying an option, whether a put or a call, result in any obligations for the option owner? Explain. The owner of a call or put has already paid the purchase price. After buying the option, the owner has only rights and no obligations. The option owner may exercise the option, sell it, or allow it to expire worthless, but the option owner is not compelled to do anything. 4. Describe all of the benefits that are associated with taking a short position in an option. Taking a short position in an option involves selling an option. Upon the sale, the seller receives a cash payment. This is the only benefit associated with selling an option. After receiving payment for the option, the seller has only potential obligations, because the seller may be required to perform at the discretion of the option owner. 5. What is the difference between a short call and a long put position? Which has rights associated with it, and which involves obligations? Explain. The short call position is obtained when a trader sells a call option. The seller of a call may be required to surrender the underlying good in exchange for the payment stated in the option contract. The short call position has a maximum benefit equal to the price that the seller received to enter the short call position. The short call position is most favorable when the price of the underlying good remains below the exercise 10 The Options Market
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66 CHAPTER 10 THE OPTIONS MARKET price. Then the seller of the call retains the full price of the option as profit. The higher the stock price above the exercise price, the worse for the call seller. In a long put position, the trader buys a put option. Owning the put gives the trader the right to sell the
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010 - 10 The Options Market Answers to Questions and...

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