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P1.T3.608. Trading and margin requirements for exchange-traded options (Hull)

Nicole Seaman

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Learning objective(s): Describe how trading, commissions, margin requirements, and exercise typically work for exchange-traded options.

Questions:

608.1. A trader has a put option contract to sell 100 shares of a stock for a strike price of $50.00. Each of the following is true EXCEPT which is not? (note: this question is based on Hull's Problem 10.24)

a. If there is a 4-for-1 stock split, the option contract becomes one to sell 400 shares with an exercise price of $12.50
b. If there is an 10.0% stock dividend, the option contract becomes one to sell 90.0 shares with an exercise price of $55.56
c. If there is $2.00 cash dividend declared, there is no effect on the contract
d. If there is a reverse 1-for-5 stock split, the option contract becomes one to sell 20 shares with an exercise price of $300.00


608.2. Hull explains the following margin requirements for a short position in naked options:

"Writing Naked Options
A naked option is an option that is not combined with an offsetting position in the underlying stock. The initial and maintenance margin required by the CBOE for a written naked call option is the greater of the following two calculations:
  1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount, if any, by which the option is out of the money
  2. A total of 100% of the option proceeds plus 10% of the underlying share price
For a written naked put option, it is the greater of
  1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount, if any, by which the option is out of the money
  2. A total of 100% of the option proceeds plus 10% of the exercise price.
The 20% in the preceding calculations is replaced by 15% for options on a broadly based stock index because a stock index is usually less volatile than the price of an individual stock. "

Question: A trader writes ten (10) naked put option contracts, with each contract being on 100 shares. The strike price is $50.00 and the stock price is currently $55.00. The option price is $3.40. The time to maturity is six months and the implied volatility is 40.0%. What is the margin requirement?

a. $3,400
b. $5,500
c. $7,300
d. $9,400


608.3. In regard to option markets, with which of the following statements would John Hull most DISAGREE?

a. If an investor sells a stock at a loss then buys a call option within 30 days, the "wash sale rule" disallows the loss as a tax deduction
b. Convertible bonds (aka, convertibles) are bonds issued by a company that can be converted into equity at certain times using a predetermined exchange ratio.; therefore, they are therefore bonds with an embedded call option on the company’s stock.
c. Because vanilla executive stock options (i.e., ESOs with a fixed strike price) profit when the company's stock increases, ESOs are an optimal tool for aligning executive compensation with shareholders, and for aligning with the company's performance relative to its peers or industry group
d. Warrants are options issued by a financial institution or nonfinancial corporation. A common use of warrants by a nonfinancial corporation is at the time of a bond issue; the corporation issues call warrants on its own stock and then attaches them to the bond issue to make it more attractive to investors

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