Markets & Products: Hull, Chapter 10

:
Trading Strategies Involving Options
FRM 2011 Practice Questions

By David Harper, CFA FRM CIPM
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Table of Contents
Question 183: Covered call and protective put ..................................................... 2
Question 184: Option spread trades .................................................................. 5
Question 185: Option combination trades ........................................................... 8

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  1

Question 183: Covered call and protective put
AIM: Explain the motivation to initiate a covered call or a protective put
strategy.
183.1. The profit pattern of a written covered call is most similar to the pattern of which naked
option trade (note: while “payoff” on the Y-axis plots the future gain/loss, “profit” nets the initial
cost of the strategy and, in these cases, does not adjust for the time value of money)?
a)
b)
c)
d)

Long call
Short call
Long put
Short put

183.2. The profit pattern of a protective put is most similar to the pattern of which naked option
trade?
a)
b)
c)
d)

Long call
Short call
Long put
Short put

183.3. A nine-month call option with a strike price of $22.00 has a price (option premium) of
$4.00 when the underlying stock price is $21.00. If a trader writes a covered call (i.e., with the
OTM call option), what are, respectively, the maximum net profit (reward) and the maximum net
loss (risk) possible? note: consistent with Hull’s profit pattern charts, please disregard the time
value of money.
a)
b)
c)
d)

$5 (max net profit) and -$17 (max net loss)
unlimited (max net profit) and -$21 (max net loss)
unlimited (max net profit) and -$17 (max net loss)
$5 (max net profit) and unlimited (max net loss)

183.4. A six-month put option with a strike price of $14.00 has a price (option premium) of
$2.00 when the underlying stock price is $18.00. If a trader employs a protective put strategy
(i.e., with the OTM put option), what are, respectively, the maximum net profit (reward) and the
maximum net loss (risk) possible? note: consistent with profit pattern charts, please disregard
the time value of money.
a)
b)
c)
d)

$14 (max net profit) and -$6 (max net loss)
unlimited (max net profit) and -$6 (max net loss)
unlimited (max net profit) and -$14 (max net loss)
unlimited (max net profit) and unlimited (max net loss)

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  2

183.5. The current price of a non-dividend-paying stock is $20.00 and the price of a six-month
European call option on the stock with a strike price of $20.00 (ATM) is $3.00. The riskfree rate
is 4.0%. What is the total initial cost to enter a protective put if we assume the trade includes a
six-month ATM put?
a)
b)
c)
d)

$3.60
$16.70
$22.00
$22.60

183.6. The current price of a non-dividend-paying stock is $20.00 and the price of a six-month
European put option on the stock with a strike price of $20.00 (ATM) is $2.00. The riskfree rate
is 4.0%. What is the total initial cost to write a covered call if we assume the trade includes a sixmonth ATM call?
a)
b)
c)
d)

$2.00
$12.40
$17.60
$22.00

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  3

Answers:
183.1. D. Written cover call resembles a short put (note both are income strategies)
Put call parity gives: p+ S(0) = c + K*exp(-rT), which re-arranges to:
S(0) - c = K*exp(-rT) - p.
The left-hand side is a covered call, which shows as Hull writes “that a long position in a stock
combined with a short position in a call [i.e., a covered call] is equivalent to a short put position
plus a certain amount of cash. This equality explains why the profit pattern [of a covered call] is
similar to the profit pattern from a short put position.”
183.2. A. Long call
Per put-call parity gives: p+ S(0) = c + K*exp(-rT).
As the left-hand side is a protective put, this shows as Hull writes “that a long position in a put
combined with a long position in the stock [i.e., protective put] is equivalent to a long call
position plus a certain amount of cash.”
183.3. A. $5 (max net profit) and -$17 (max net loss)
On the upside, the gain is capped at $4 for the collected premium on the written call + $1 on the
difference between $22 and $21.
On the downside, the worst case is the stock drops to zero which implies a loss of $21 on the
purchased stock but mitigated by the $4 collected premium ($17 = $21 - 4); the written option
will not be expired.
The covered call is an income strategy: in exchange for the extra income of the option premium
received, the upside is capped.
183.4. B. unlimited (max net profit) and -$6 (max net loss)
The upside is unlimited: the purchased put reduces the net profit by the premium, but the profit
is still unlimited.
On the downside, loss is -2 for the option premium paid plus -4 (14 - 18 = -4) equals capped
downside of a loss of $6.
The protective put is an insurance strategy; in exchange for forgoing upside (option premium
paid) the loss is capped.
183.5. D. $22.60
Per put-call parity the protective put = S(0) + p = c + K*exp(-rT) = 3 + 20*exp(-4%*0.5) =
$22.603
183.6. C. $17.60
Per put-call parity S(0) + p = c + K*exp(-rT), such that a written call is given by:
S(0) - c = K*exp(-rT) - p = 20*exp(-rT) - 2 = $17.60; i.e., the call price is $2.40 and $20 - $2.40 =
$17.60.
That is, pay for the stock @ $20 and collect $2.40 in call premium.

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  4

Question 184: Option spread trades
AIMs: Describe and explain the use and payoff functions of spread
strategies, including bull spread, bear spread, box spread, calendar
spread, butterfly spread, and diagonal spread.
Calculate the pay-offs of various spread strategies.
Reminder: A spread trading strategy involves taking a position in two or more options of
the same type (i.e., two or more calls or two or more puts).
184.1. The price of a stock is currently $20.00. An OTM call option on the stock has a strike at
$22.00 and costs $2.00. An OTM call option with a strike of $26.00 costs $0.95. If an investor
uses both of these options to enter a BULL SPREAD trade, what is the trade’s maximum return
on investment (ROI) where ROI = maximum profit / initial cost, without regard to time value of
money?
a)
b)
c)
d)

85%
187%
281%
364%

184.2. Assume two OTM put options on an stock with a current price of $30: the first put option
has a strike at $25 and costs $1, the second put option has a strike at $28 and costs $2. Ignoring
the time value of money, if an investor enters a BEAR SPREAD trade, at what future stock price
does the strategy break-even (break-even is when the strategy’s profit is zero)?
a)
b)
c)
d)

$26
$27
$28
$29

184.3. The stock of ACME company is currently trading at $20.00. At a strike price of $16.00, a
call option costs $6.00 and a put option costs $1.37. At a strike of $24.00, a call option costs
$1.20 and a put option costs $4.26. All of the options are European with one year to expiration.
The risk-free rate is 4.0% per annum continuously compounded. What is the present value (PV)
of the future PAYOFF of a BOX SPREAD strategy (note: while “profit” nets the initial cost, “payoff”
does not net the initial cost)
a)
b)
c)
d)

Zero
$1.15
$7.69
$8.00

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  5

184.4. Two traders each employ CALENDAR SPREAD trades with identical shorter-dated and
longer-dated maturities: Trader C employs a calendar spread with a three-month and a ninemonth call option, while Trader P employs a calendar spread with a three-month and a ninemonth put option; for all options, the strike are at $20.00 which is at-the-money (ATM). When
the shorter-maturity options expires in three months, which scenario is most profitable (profit
net of initial cost) to the traders?
a) For both traders, if the stock is well ABOVE the $20 strike
b) For both traders, if the stock is well BELOW the $20 strike
c) For the trader using calls, if the stock is well above $20; for the trader using puts, if the

stock is well below $20
d) For both traders, if the stock is near, or equal to, the $20 strike
184.5. Which of the following strategies is most profitable (net of initial cost) if the underlying
stock price increases dramatically?
a)
b)
c)
d)

Bull spread with puts
Bear spread with puts
Butterfly spread with calls
Calendar spread with calls

184.6. The stock of ACME company is currently trading at $20.00. There are three call options on
the stock: an ITM call option with a strike at $16.00 costs $5.00; an ATM call option with a strike
at $20.00 costs $2.45; and an OTM call option with a strike at $24.00 costs $1.00. If an investor
enters a long call BUTTERFLY SPREAD trade, what is the maximum return on investment (ROI)
where ROI = maximum profit / initial cost, without regard to time value of money?
a)
b)
c)
d)

93%
167%
265%
233%

184.7. With respect to option spread trade strategies, consider the following statements:
I.
II.
III.
IV.

A long call option plus a short call option on the same stock can create the
following trades: bull spread, bear spread, calendar spread, and diagonal spread
In the case of a bull or bear spread, the call options have the same expiration date
but different strike prices
In the case of a calendar spread, the call options have the same strike price but
different expiration dates
In the case of a diagonal spread, the call options have both different strike prices
and different expiration dates

Which of the above statements is (are) true?
a)
b)
c)
d)

I. and IV. Only
II. and III. Only
II., III. and IV.
All of the above

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  6

Answers:
184.1. C. 281%
Bull spread: BUY call option with lower strike (K = 22) and SELL call option with higher strike
price (K = 26).
Initial cost = buy $2 call and sell $0.95 call = $1.05 net initial cost
Maximum profit = max payoff - initial cost = (difference in strike prices) - initial cost = $4.00 $1.05 = $2.95
Maximum ROI = 2.95/1.05 = 281%
184.2. B. $27
The initial cost of the bear spread is $1 as it costs $2 to purchase the put with the higher strike
price and $1 is received by selling the other put.
Therefore, break-even occurs if the stock price reaches $27 because, while one put option is
OTM, the other is exercised for a $1 gain.
(in briefer terms, breakeven stock price for a bear spread = higher strike price - initial cost = 28 1 = $27)
184.3. C. $7.69, which is the initial cost of the strategy
Because the box spread is not profitable, the PV(future payoff) must equal the initial cost. In this
case,
Initial cost = pay (6.00 + 4.26) and receive (1.37 + 1.20) = 10.26 - 2.57 = $7.69;
(Future) payoff of box spread = difference in strike prices = 24 - 16 = $8.00, and
$7.69 = $8.00*exp(-4%*1), such that PV (payoff) = initial cost = $7.69, which gives profit of zero
(if we incorporate time value of money; please note that without time value of money, profit = 8
- 7.69 = $0.31)
184.4. D. If the stock is near or equal to the $20 strike, for both traders
For calendar spread trades (employing either calls or puts), the strategy is most profitable when
the stock price equals the strike prices when the short-dated option expires; i.e., in that case, the
sold option expires worthlessly and the purchased option still has value (time value).
184.5. A. Bull spread with puts. An income strategy: at high stock prices, neither option is
exercised and the initial receipt is retained.
In regard to (B), neither option is exercised but the initial cost represents a loss (this strategy is
a bet on a price decline).
In regard to (C) and (D), both the butterfly and calendar spread strategies imply net losses given
extreme price moves in either directions.
184.6. C. 265%
Long call butterfly spread = Long ITM call + Long OTM call + Short Two ATM calls. In this case:
Initial cost = $5 + $1 - (2 * 2.45) = $1.10
Max payoff occurs if remains at the middle strike price of $20, in which case future payoff (due
to ITM call) = $4.00.
Max profit = $4.00 - $1.10 = $2.90, such that max ROI = 2.90/1.10 = 265%
184.7. D. All of the above

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  7

Question 185: Option combination trades
AIMs: Describe and explain the use and payoff functions of combination
strategies, including straddles, strangles, strips, and straps. Compute the
pay-offs of combination strategies.
185.1. The price of a stock is currently $20.00. A three-month (T = 0.25 years) ATM call option
on the stock with a strike at $20.00 costs $1.25. The riskless rate is 4.0%. If an investor
purchases a STRADDLE (i.e., bottom straddle) that includes this call option, what is the
investor’s maximum risk (loss) and maximum reward (payoff) potential, respectively, without
regard to time value of money?
a)
b)
c)
d)

zero (max risk) and uncapped (max reward)
$0.80 (max risk) and $9.90 (max reward)
$1.25 (max risk) and $17.70 (max reward)
$2.30 (max risk) and $17.70 (max reward)

185.2. An investor purchases a (bottom) straddle with at-the-money (ATM) options. The
percentage delta (i.e., delta per option) of the ATM call option is + 0.62; for example, if she
purchases 100 call options, then the position delta is 0.62 percentage delta * 100 options = +62
position delta. At the time of purchase, what is the position delta of the long straddle?
a)
b)
c)
d)

Negative
Zero
Positive
Need more information

185.3. John predicts that Groupon’s stock (ticker: GRPN) is going to see big move, soon, in either
direction: he thinks the stock should either spike up, or plummet, dramatically. He therefore
predicts the stock will do anything except remain range-bound. His plan is to purchase straddles.
His college Andrea argues for a STRANGLE instead. Her argument in favor of a strangle, over a
straddle, employs each of the following EXCEPT:
a) The strangle has a lower initial investment (total premiums) than the straddle
b) As the stock moves up or down, the strangle reaches breakeven “sooner” (requires less

of an up/down in the asset price) than the straddle
c) The strangle has less maximum downside (risk) than the straddle
d) The strangle retains two of the straddle’s advantages: it remains a volatility strategy with

an uncapped payoff if the stock rises

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  8

185.4. Consider the following statements about strips and straps:
I.
II.
III.
IV.

A strip is a straddle plus long one put option, and is therefore bearish
A strap is a straddle plus long one call option, and is therefore bullish
Both the strip and strap are volatility trades: uncapped potential reward under big
price moves but a losing trade under range-bound scenarios
Both the strip and strap are cheaper than the straddle

Which of the above are correct?
a)
b)
c)
d)

I. and III.
II. and IV.
I., II. and III.
All of them

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  9

Answers:
185.1. D. $2.30 (max risk) and $17.70 (max reward)
Did you remember to use put-call parity to infer the price of the put (a straddle is the long/short
of call and put with same strike and remaining term)?
As p = c + K*exp(-rT) - S, in this case, p = 1.25 + 20*exp(-4%*0.25) - 20 = $1.05.
The maximum risk is the total initial (option premiums) investment = $1.25 + $1.05 = $2.30.
The maximum reward, while sometimes consider uncapped (this is really “virtually”), occurs if
the stock drops to zero, such that max reward = $20.00 max payoff on the put - $2.30 investment
= $17.70.
185.2. C. Positive
Since the call and put have the same strike and expiration (and the underlying asset price and
volatility are the same), we should know that delta put = delta call -1; i.e., delta put = N(d1) -1.
Technically, this is an FRM Part 2 (Level 2) concept but delta has Part 2 influences and you’ll
need to know this anyway, this is useful!
In this case, as the percentage delta of the call is 0.62, the percentage delta of the put is 0.62 - 1 =
-0.38.
Regardless of the quantity, the position delta is positive, somewhere between the call delta and
the put delta:
Percentage delta of long straddle = [0.62 + (-0.38)] = 0.24
Position delta of long straddle = [0.62 + (-0.38)] * quantity of options = 0.24 * quantity of options
Please note this only applies immediately, while both call and put are ATM, the deltas vary as the
underlying varies so the straddle delta can go negative as the underlying price drops; e.g., at a
very low stock price, the investor is long deep OTM calls (delta approaching zero) plus long deep
ITM puts (delta approaching -1.0).
185.3. B. False. The disadvantage of the strangle is that breakeven points are further
apart, than under the straddle. (the strangle purchases two OTM options: this lowers the
total premium at the cost of widening the breakeven points).
In regard to (A), (C) and (D), there are EACH advantages of the strangle over the straddle; please
note (A) and (C) are identical really.,
185.4. C. I., II. and III.
In regard to (D), as the strip and strap require the purchase of three options instead of two,
these strategies are more expensive initially than the straddle.

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FRM 2011  MARKETS & PRODUCTS: HULL, CHAPTER 10  10