Retaker here, started my prep in January and have consistently studied.
I just did the level 3 mock and got 46/60, it felt easier than last year’s paper.
I have a two q’s for any one who did it.
q38, why was number of equity future contracts not determined as (1.15-0.25)/1.05 x(5500000000/1525000). Why did they start from a duration of zero rathen that 0.25
q43, the answer stated he is incorrect about covered calls Why does covered calls niot protect from losses. I have an idea but would like a thorough explanation.
By the way, guys we are killing Level 3 this year. I am feeling so pumped already.
I haven’t read question 43, but regarding covered calls, this is a combination of long stock + short call option. So if you think of the payoff graph, the value of the covered call is equivalent to the value of a long stock, up until you reach the strike price of the option, at which point, no matter how much higher the value of the stock goes up, your payoff is capped (the gain in your long position is canceled out by the loss from your in-the-money option position).
In conclusion, a covered call provides a capped gain with no downside protection. The benefit is that you get the premium for shorting the call option. If your underlying stock posts losses, your long position will lose money, and your short call will expire worthless, having only provided you with the initial premium. Total loss = Loss on the stock - the premium you received on the option.
Ah, I think I see where you made the error. When St < X, the payoff is equivalent to St - (S0-C0). Yes, the minimum payoff (if the stock falls to 0) is 0 - (S0 - C0), which is equivalent to a max loss of S0 - C0 as you said. But just because the max loss is a constant number doesn’t mean you have loss protection, since in this case, the max loss occurs when your position falls to 0.
That’s like saying, if I’m long a stock, the max loss is equal to the price that I paid for the stock (i.e. a constant number S0). Yes, this is true, but I wouldn’t say that being long a stock offers loss protection.
I guess the phrase “downside protection” is relative to the price you paid for the position. If you paid X for something, then “downside protection” probably means you are guaranteed not to lose X or more.
The diagram of a covered call = same as a Short Put strategy.
So unlimited losses are possible.
the S0 - C0 only applies so long as the Underlying remains in that range.
Unlimited Loss Potential
Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. However, this risk is no different from that which the typical stockowner is exposed to. In fact, the covered call writer’s loss is cushioned slightly by the premiums received for writing the calls.
The formula for calculating loss is given below:
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying < Purchase Price of Underlying - Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid
I’m pretty sure a covered call and a short position do not have unlimited max loss. They do have the same diagram shape, but when the stock price hits 0, their loss is capped.
The only basic option position that has an infinite loss is a short call, theoretically.
Let me put this a different way and hopefully my noggin will get it. I think we all agree that the put provides downside protection.
When I considerr the max loss from a put it is (X-(Po+S0)) ( just worked it out in my head so may be incorrect)
Again , to me it is a constant number, so how comes the put provides down side protection but not the covered call.
I see the covered call as covering a naked position. If the we just short the call option the loss would be unlimited when the share price goes up so by going long the stock we cover the loss.
You are correct in that, when the share price is greater than the strike price, the loss on your short call is covered by the gain the stock. Your short call position IS loss protected due to the long stock. But in going long the stock, you are now exposed to loss when share price is below strike price, so when share is less than strike, you’re exposed to a loss.
If you own a stock, and purchase a put option, the put ensures you will not lose any more money. If the stock goes down, your put cancels the loss. If your stock goes up, your stock makes money. Since you are not losing anything once you’ve entered the position, you are loss protected.
If you own a stock, and short a call option, you can still end up losing more money. When the share price declines, your long position loses money.
A long call option is loss-protected because once you pay that initial premium, you cannot lose any more money from the position. No matter what happens, the most you lose is what you paid for initially.
Again, it’s like saying if I’m long a stock, am I loss protected? The most I can lose is S0 which is a constant number, right? But I’m not really protected against loss because the value of my position can decline.