Answers to Options Basics Quiz

Do you Know the Basics?

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The Quiz Kids; 1940s. Google Images

The quiz was designed to encourage readers to be certain that they understand the basic concepts of options -- before moving on to more advanced material.

If you are new to stock options and had a few lessons, viewed seminar videos, or read one or more books, it is a good idea determine how well you absorbed the material. Please do not make the mistake of believing that this stuff is so easy to understand that you can satisfy your eagerness to get started trading options.

A solid background will make the entire options-education process much more efficient. And more importantly, it will also make it more profitable.

ANSWERS
 

1. True. When you buy options losses are limited to the cash paid to buy the options.

2. False. When you sell call options (without buying any other call options) your losses are theoretically unlimited because the price of the underlying stock has no upper limit. 

3. You own one option: XYZ Feb 16 '15 75 call.
          The strike price is $75 per share.
          The option expires when the market closes for trading on Feb 16, 2015.
          XYZ is the underlying asset.

4. If you exercise a call option (and you must own it before you may exercise), you purchase 100 shares of the underlying asset and pay the strike price per share. This transaction is made automatically once the option is exercised. The next business day your account will show that you now own 100 shares of the underlying asset, and that the cash to pay for those shares has been removed.

   

5. If you are  on an option that you own, what happens? Nothing happens. You cannot be assigned an exercise notice unless your account is short (i.e., you sold and have not repurchased) an unexpired option.

If you are assigned on an option that you are short, you must honor the conditions of the option contract.

If you are assigned on a call option, you must sell 100 shares (even if you do not own the shares) of the underlying asset at the strike price. If you are assigned on a put option, you must buy 100 shares at the strike price.

6. When you buy or sell any option(s), do you have to be concerned about the person on the other side of the trade? If he/she goes bankrupt, is your option still valid? Do not be concerned because the option contract is guaranteed (i.e., it remains valid) by the OCC (Options Clearing Corporation). 

7. All options work exactly the same way, regardless of whether the underlying asset is a stock, ETF, or Index? True or False?  False. There are two distinct kinds of options. Options on individual stocks are American style options while some broad-based index options are European Style. They are very different. You can read about those differences here

8. You instruct your broker to buy 10 ABCD Nov 18 '16 45 calls at the  price of $1.35, or better. A few seconds later you receive confirmation that you bought those 10 calls at $1.40 each. Is that ok with you? No. When you enter a limit order to buy options, you cannot pay more than the limit price. Call the broker and tell them that they made a mistake.  When you enter a limit order to buy options, you cannot pay more than the limit price.

9. You instruct your broker to buy a calendar spread. Using a limit order, you want to buy 3 IBM April calls and sell 3 IBM March calls. The limit price is $2.00, or better. At the end of the day, your broker tells you that you bought the April calls but that he was unable to sell the March calls. Your position is now long 3 IBM April calls. Is that ok with you? No. When you enter a spread order, you must be filled on all (or none) of the options that are part of the spread. Note the whole order does not have to be filled. Translation: it is possible to trade fewer spreads (less than 3 in this example), but under no circumstances may your broker fill part of a spread but not the other part.

10. You sold 6 RGTO puts with a strike price of $20 per share. When expiration arrives, you are still short those puts (i.e., you never bought those options to close the position).

The closing price for this stock on expiration Friday is $19.87. What, if anything, do you expect to happen? Expect that you will be assigned an exercise notice on all 6 put options, making you obligated to buy 600 shares of RGTO at $20 per share. When you see your account on Monday, the transaction will have already taken place.  The 600 shares are in your account and $12,000 (plus a commission) has been removed.

Bonus question: 11. This is a much less common situation. Do you know the rules? You own 3 GE (General Electric) put options with a strike price of $25. At expiration, you still own the options (this is a mistake because you should have sold them) and the stock price is $24.99.  You call the broker one minute after the market closes on expiration Friday, and he tells you that there is nothing you can do -- they cannot be sold because the options stopped trading when the closing bell rang -- and that these options (according to the option-trading rules) will be exercised automatically for you. As a result you will sell 300 shares of GE at $25 per share. This is not what you want. Was your broker correct when telling you that there is nothing that can be done to prevent this automatic exercise? No. Your broker made a mistake. You have the right to submit a DO NOT EXERCISE NOTICE for any in-the-money option that you own, but do not want to exercise. Warning: There is a very short time window for taking this action. Call immediately after the close - or even before the close of trading - to exercise your right to make this decision. Ask your broker what their cutoff time is for submitting this notice. NOTE: You also have the right to exercise an option that is out of the money (this is a very rare occurrence) by submitting a DO EXERCISE notice. 

          

It is important to know the correct answers for questions 1 through 10.