Characteristics of Derivative Securities

A is correct. This is a covered call strategy, where the investor generates income from the $2 premium while maintaining ownership of the stock. However, if the stock rises above $55, the shares will likely be called away, limiting upside profit to $5 per share (from $50 to $55) plus the $2 premium received.

B (Protect against downside) is incorrect because the covered call only provides $2 of downside protection from the premium received, not full protection below $48. C (Profit from volatility) is incorrect because that describes a straddle or strangle strategy, not a covered call. D (Speculate on decline) is incorrect because covered calls are used with a bullish to neutral outlook, not a bearish one.

C is correct. This is a protective put strategy. The maximum loss occurs if the stock falls to zero and the put is exercised. The investor bought stock at $60 and can sell it at the $55 strike price, losing $5 per share on the stock. Add the $3 premium paid for the put, and the total maximum loss is $8 per share.

A ($3) is incorrect because it only accounts for the premium paid, ignoring the stock loss. B ($5) is incorrect because it only accounts for the difference between purchase price and strike price, forgetting the put premium cost. D (Unlimited) is incorrect because the put option caps the downside loss at the strike price, which is the whole purpose of portfolio insurance.

B is correct. The intrinsic value of a call option is calculated as MAX(0, stock price minus strike price). In this case: $47 (stock price) minus $40 (strike price) equals $7. This represents the amount the option is "in the money."

C ($9) is incorrect because that's the total premium, not just the intrinsic value. The premium includes both intrinsic value ($7) and time value ($2). A ($2) is incorrect because that's the time value component, calculated as premium ($9) minus intrinsic value ($7). D ($47) is incorrect because intrinsic value is not the stock price itself, but rather how much the option is in the money.

D is correct. Time value decays to zero as an option approaches expiration. This phenomenon, measured by theta, represents the erosion of the option's extrinsic value as the time window for profitable movement shrinks. At expiration, an option has only intrinsic value (if any) remaining.

A (Increases) is incorrect because time value always decreases as expiration approaches, never increases. The passage of time works against option buyers. B (Remains constant) is incorrect because time decay is continuous and accelerates near expiration. C (Converts to intrinsic) is incorrect because time value doesn't convert to intrinsic value. Time value simply disappears while intrinsic value depends solely on the relationship between stock price and strike price.

C is correct. The breakeven point for a long call is the strike price plus the premium paid. In this case: $50 (strike) + $3 (premium) = $53. At $53, the investor can exercise the option to buy at $50 and immediately sell at $53, recovering the $3 premium paid with zero profit or loss.

B ($50) is incorrect because at the strike price, the investor would lose the entire $3 premium paid. The stock must rise above the strike by the amount of the premium to break even. A ($47) is incorrect because that would be the breakeven for a put option (strike minus premium), not a call. D ($56) is incorrect because it adds twice the premium amount, which is a common calculation error.

B is correct. American-style options can be exercised at any time before the expiration date, giving the holder maximum flexibility. This is the defining characteristic that distinguishes them from European-style options, which can only be exercised at expiration.

A (U.S. exchanges only) is incorrect because the terms "American" and "European" refer to exercise style, not geographic trading location. European-style options trade in the U.S. C (Longer periods) is incorrect because exercise style has nothing to do with the length of the option's life. D (Foreign securities) is incorrect because both American and European-style options can be written on domestic or foreign securities. The names refer to exercise flexibility, not the underlying security's origin.

D is correct. Delta measures the change in option premium relative to a $1 change in the underlying stock price. With a delta of 0.60, a $2 increase in stock price produces approximately a $1.20 increase in option premium (0.60 × $2 = $1.20).

B ($0.60) is incorrect because it only accounts for a $1 stock price change, not the actual $2 change in the question. A ($0.30) is incorrect because it divides delta by 2 instead of multiplying it by the stock price change. C ($2.00) is incorrect because it assumes a delta of 1.0, meaning the option moves dollar-for-dollar with the stock, which only happens with deep in-the-money options.

B is correct. A protective put acts as insurance against downside risk while allowing the investor to maintain the stock position and participate in upside potential. This is ideal for temporary protection around known risk events like earnings announcements while preserving long-term holdings.

A (Covered call) is incorrect because it generates income but provides minimal downside protection (only the premium received) and caps upside potential if the stock rallies. C (Naked put) is incorrect because selling a put creates obligation to buy more stock at the strike price, which doesn't protect the existing position and actually increases exposure. D (Buy a call) is incorrect because the investor already owns the stock and doesn't need the right to buy more shares.

D is correct. A long straddle involves buying both a call and a put at the same strike price. This strategy profits from large price movements in either direction. The investor pays two premiums but gains if the stock moves significantly up or down, making it ideal when expecting volatility without knowing the direction.

A (Covered call) is incorrect because it's an income strategy with limited profit potential, not a volatility play. B (Protective put) is incorrect because it's designed to protect an existing stock position against downside risk, not profit from volatility in either direction. C (Bull call spread) is incorrect because it's a directional strategy that profits only from upward price movement, not movement in either direction.

A is correct. The maximum profit for a bull call spread is the difference between strike prices minus the net premium paid. Strike difference: $50 minus $45 equals $5. Net premium paid: $5 (paid for long call) minus $2 (received for short call) equals $3. Maximum profit: $5 minus $3 equals $2 per share. This occurs if the stock closes at or above $50 at expiration.

C ($5) is incorrect because it only accounts for the spread width without subtracting the net cost. B ($3) is incorrect because that's the net premium paid (the maximum loss), not the maximum profit. D (Unlimited) is incorrect because the short call at $50 caps the upside profit potential. Unlike a naked long call, spreads have defined maximum profit.