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Smart Profits Quiz

The Smart Profits Report: Issue #242
Friday, September 16, 2005

Smart Profits Quiz: Test Your Options Knowledge
By Karim Rahemtulla
Chairman, Mt. Vernon Research

You’ve been reading this newsletter for some time now… And just aching to jump into some trades - LEAPS, puts, calls and more. Options greatness is just around the corner… At least I hope so.

But just to test the water, I’ve put together five questions to keep you on your toes, just to see how far we’ve come.

Take a moment to take this Smart Profits quiz. When you’re finished, hop down to the answers below to see how “smart” you really are… Good luck.

Smart Profits Pop Quiz

  • What is covered call writing?

    a. An option bought over the phone with your broker.
    b. Buying a stock and selling options against the same issue.
    c. The printed contract you receive in the mail after your trade is placed.
    d. A paper trading exercise your broker requires before you’re given an options account.
  • What are LEAPS?

    a. Call or put options that don’t expire for at least nine months.
    b. A contract with a “bridge” feature for down-market trends.
    c. “Leveraged Agent Put Signals”
    d. “Leased Earnings Price Swap”

  • Say you purchased a November $30 put on XYZ, and it cost you $1.50. What happens to the value of that put when XYZ has a strong week and trades at $35?

    a. It powers forward at a greater pace due to its increased leverage.
    b. Your put’s value stays the same because it doesn’t expire until November.
    c. The IRS calls you immediately.
    d. The value decreases.

  • What’s the best way to place an options order?

    a. Use limit orders.
    b. Only buy options with expirations more than a month away.
    c. Pay less than $40 in commissions.
    d. Up your buying power with a lump sum from your 401k.

  • Which of the following is an advantage of buying call options?

    a. They give you the right to sell a stock before you lose.
    b. Buying calls gets you more respect in the trading world.
    c. Calls let you buy expensive stocks at a fraction of the cost.
    d. Calls require less attention than stocks because of their smaller price movements.

Answers:

1. B: Covered call writing is a way to take advantage of options’ risk-reducing functions. We do this by placing two trades: 1) We purchase the actual stock, and 2) we sell options against that same stock (I like selling deep-in-the-money calls). Now, we’re not only reducing our cost (reduced risk) of the first trade by adding money in our accounts, we’re also poised to win if the stock moves higher, lower, or even stays flat. Revisit Smart Profits #128, Writing Covered Calls - How to Double Your Stock Profits with Options or check out our Smart Profits Glossary for more on covered calls.

2. A: LEAPS are Long-term Equity Anticipation Securities - they are no less than nine months from expiration. They are great for taking a position in a stock you “anticipate” moving higher over a longer period of time, and, like all options, they allow us to use less cash up front than stocks. There’s a strategy I really like called Swap Trading that uses LEAPS, which I explain in Smart Profits #159, LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns.

3. D: Your put value decreases because it represents the option to sell the underlying stock at $30. If the stock headed south, for example, and hit $25, then our option to sell it at $30 would be pretty attractive, and would give us a healthy win. I talk more about buying puts in Smart Profits #102, Put Options: Why Short a Stock when You Can Buy a Put?

4. A, B and C: These are great tips. For examples of these three winning rules for placing option orders, and one other one, see Smart Profits #212, Beating the Market Makers: Never Pay Full Price.

5. C: Call options are great ways to get into a position without using a lot of your principal. Let’s say I like stock XYZ again, and it’s trading at $100 per share now, with the January 2007 $120 LEAPS trading at $1.75. If I want 500 shares of the actual stock, we’re talking about a very big number just to get in - $50,000, to be exact. But, if I buy the LEAPS option, my cost to get in just dropped to $750 to control the same number of shares. That’s a big difference! Check out Smart Profits #101, Call Options: Why Would Anyone Buy A Call?

What’s your score?

5 - Hedge Fund Manager
4 - Options Analyst
3 - Account Maintenance Specialist at your favorite brokerage firm
2 - Trading Workshop Attendee
1 - Run to the doughnut shop to get your superior’s coffee and crullers.

Good trading,

Karim

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