1. What is the most important difference between a trader who is hedging and a t
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1. What is the most important difference between a trader who is hedging and a trader who is speculating? (Select the best answer.) A. A trader who is hedging is attempting to reduce risk, whereas a speculator is taking on risk. B. A trader who is hedging most likely is a business, whereas a speculator most likely is an individual. C. A trader who is hedging is limited to using futures, whereas a speculator may use any financial asset. D. A trader who is hedging is trying to eliminate all risk, whereas a speculator is only attempting to reduce downside risk. E. A trader who is hedging will achieve the best results with put options, whereas a speculator will achieve the best results with call options. 2. Suppose that a trader would like to invest in a stock but also wants to establish protection from downside risk. Which of the following strategies would lock in on a purchase price today with protection should the price fall before the stock is purchased? A. Buy the box. B. Take a short position in a call option and a long position in a put option, both on the same stock and with the same expiration date. C. Write a covered call on the stock that the trader would like to buy. D. Buy a put option on the stock that the trader would like to buy E. Buy a call option on the stock, and invest the present value of the strike price at the risk-free rate.Explanation / Answer
1. A trader who is hedging, is trying to eliminate risk while speculator is one who bets on the basis of direction of market to gain profits. Out of the options given, option D is best suited.
2. A trader wants to purchase a stock while he wants to establish protection against downside risk. Option B would enable the person to lock in on purchase price today with protection if the price of stock falls before purchase. As in the second option, a trader will have protective put with downside protection for the stock he intends to purchase.However he has to incur the cost for this position in the form of premium of put option. To offset this cost he can simaltaneously write a call with same strike price and gain the premium when price of underlying stock falls below strike price. Answer is option B.
3. A covered call strategy means owing a stock and sell a call on that stock. This caps the upside potential on the stock owned. Option E is the best suited answer.
4. An investor buys a call with strike price of $30 with premium $3. Writes a call with Strike Price of $ 35 for a premium of $1. Here the invsetor is buying a call with lower strike price and subsidises the cost of buying with selling or writing a call with higher strike price and gaining premium. The strategy is known as Bull Spread using Call Options .. Best suited option is Option C.
5. A trader buys a 2 month put option with strike price of $35 at a premium of $ 3. and write Two months put with strike price of $30 at premium of $1. This strategy is known as Bear Spread using put option. Where a trader buys a put option with higher Strike price and writes a put option with lower strike price. Answer is option B.
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