Sorry for another post on the PM mocks but im not satisfied with the answer provided
Questions asks about using options to manage his common stock position and which statement is incorrect.
C) is obviously correct, thus not the right choice.
A) Seems somewhat wrong but it’s not totally clear what they mean by a ‘minimum value’ - I’m thinking (after the fact) they intend to say a floor value?
B) Reduction of volatility (of his position) - Not sure if they mean volatility of returns or exposure to vol (via long options)? The long option would be long vol while the short call would be short vol so being long a put option would not reduce volatility.
For A -> What is a minimum value? Selling covered calls would create a minimum value equal to the value of the short option. They mean floor right, i.e, protect the position by establishing a floor value? if they had said delta hedged via short calls would this establish a ‘minimum value’?
For B - Being long a protective put would increase exposure to option volatility but when they say volatility do they mean return volatility? What’s the key word here the seperates option vol exposure vs. return vol exposure (if that’s what they even intended to say!)
Section in the text that talks about calls establishing a ‘liquidation value’ - AKA MINIMUM?
“The strategy effectively allows the investor to establish a liquidation value (the strike price) for the shares he or she writes call options against. However, the investor does retain full downside exposure to the shares (to the extent the stock price decreases by more than the premium received) and has capped the upside potential (the call strike price plus the premium received).” (Institute 170) Institute, CFA. 2015 CFA Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. Wiley Global Finance, 2014-07-14. VitalBook file. The citation provided is a guideline. Please check each citation for accuracy before use.
Minimum value is floor value. Also, covered calls CAP the value. They retain full downside (except reduced by the calloption premium), and they cap the upside at the strike price of the call option.
A protective put will eliminate downside risk below the floor, hence there is only upside volatility (which is the same as w/o the option) and hence the overeall volatility as decreased.
REgarding the liquidation value, it is a MAX value. the investor retains full downside because the option buyer will not exercise below the strike price, only when it goe above.