Which of the following positions will mitigate the risk of a short call position Quizlet

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I, II, and III

Explanation: If investors are long stock, they can lock in an existing profit, or protect themselves against a market decline, by buying a put. If the market price continues to rise, investors will realize an additional profit, minus the premium paid for the put. For example, an investor owns stock that has a current market value of $60 and buys a July 60 put for 3. If the market price advances to $70, there will be an additional profit of $700 ($1,000 increase in profit minus $300 premium).

The investor can provide protection against a loss by using a put. For example, if the stock in the preceding example dropped to $40, the investor would exercise the put and sell stock at $60. The entire cost would be the premium of $300.

c. A put writer who sells the underlying stock short

Explanation: All of these positions describe covered option writers. However, in the first two choices, if the market price of the stock rises, the call is exercised against the investor and she is obligated to sell the underlying stock. In both cases, she is long the security to fulfill her obligation. In choice (a), she has the stock if it is called away and, in choice (b), she can convert the bonds into stock that she is obligated to deliver when the option is exercised. With both of these choices, the loss is limited, since the stock can only decline to zero. In the case of the convertible bonds, if the stock price falls, the bonds may still have some value depending on the issuing corporation.

In choices (c) and (d), the put would be exercised against the investor if the price of the underlying stock declines. In both cases, the investor will have the cash needed to purchase the stock if exercised. If the price of the underlying stock rises, the put option would expire. However, in choice (c), the investor is short the stock and, therefore, has unlimited risk potential.

d. $7,050

Explanation: Ms. Green has written 3 covered calls and 3 uncovered puts. In both cases, the maximum loss occurs if the underlying stock (RSW) becomes worthless. If the market price of RSW is zero, the 3 covered calls would result in a $4,200 loss (300 shares x $15 purchase price - $300 premium received). At zero, the 3 uncovered puts are exercised for a net loss of $2,850 (3 contracts x $10 strike price - the premium received of $150). Thus, the total loss is $7,050 ($4,200 + $2,850).

A butterfly spread is a market neutral position that is created by combining a "long" spread with a "short spread." It is called a "butterfly" because the 2 "outer" long positions are the wings of the butterfly, while the 2 short positions at the same strike are the "body" of the butterfly/
The position is established with a small debit that establishes the maximum potential loss if the market moves broadly up or down. If the market stays right in the middle ($60 in this example), the gain is maximized. Here is what happens as the market moves:
Market is at $55 or lower: All positions expire and the net $1 debit is lost.
Market moves to $56: $1 is gained on the long 55 call, offsetting the $1 debit = breakeven.
Market moves to $57: $2 is gained on the long 55 call, offset by the $1 debit = $1 profit
Market moves to $58: $3 is gained on the long 55 call, offset by the $1 debit = $2 profit
Market moves to $59: $4 is gained on the long 55 call, offset by the $1 debit = $3 profit
Market moves to $60: $5 is gained on the long 55 call, offset by the $1 debit = $4 profit. This is the maximum potential gain.
Market moves to $61: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $1 loss on the other short 60 call and the $1 debit = $3 profit
Market moves to $62: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $2 loss on the other short 60 call and the $1 debit = $2 profit
Market moves to $63: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $3 loss on the other short 60 call and the $1 debit = $1 profit
Market moves to $64: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $4 loss on the other short 60 call and the $1 debit = $0 profit. This is the upside breakeven.
Market moves to $65 or higher: All positions are exercised. $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $5 loss on the exercise other short 60 call and the long 65 call. The loss is the debit of $1.

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