An investor buys a straddle (long call + long put at the same strike) on a stock before an earnings announcement. The stock barely moves after the announcement. What happens to the investor's position?
AShe profits because the call gains value as the put loses value, netting a gain
BShe breaks even because gains on one leg always offset losses on the other
CShe loses money — both options expire near worthless, and she paid premium for both
DShe profits because implied volatility typically rises around earnings announcements
A straddle's profit depends on the magnitude of the move, not its direction. If the underlying barely moves, both the call and the put expire near worthless, and the investor loses the combined premium paid. To profit, the stock must move enough in either direction to exceed the total premium cost. This is a bet that realized volatility will exceed the implied volatility priced into the options. A minimal stock move is exactly the scenario where straddles fail.
Question 2 Multiple Choice
How does a bull call spread differ from simply buying a call, and what is the tradeoff?
AA spread always has higher profit potential than a single call, with the same premium cost
BA spread buys a call at a lower strike and sells a call at a higher strike — reducing net premium but capping gains above the upper strike
CA spread requires less capital because you sell the put rather than the call at the higher strike
DA spread is directionally neutral, while buying a single call expresses a bullish view
A bull call spread buys a call at strike K₁ and sells a call at strike K₂ > K₁. The premium received from the upper call reduces your net cost vs. buying only the lower-strike call. But you give up profits above K₂, since gains on the long call are offset by losses on the short call beyond that point. The tradeoff is explicit: lower net premium in exchange for capped maximum profit. Both the single call and the spread are bullish, but the spread expresses a more precise view — 'the stock will rise moderately, not dramatically above K₂.'
Question 3 True / False
Buying a straddle is primarily a directional bet — you profit when the stock rises significantly.
TTrue
FFalse
Answer: False
A straddle profits from large movement in either direction. Buying both a call and a put at the same strike means you gain whether the stock surges upward or crashes downward — as long as the move exceeds the combined premium paid. This makes a straddle a volatility bet: you are betting that realized volatility will exceed what the market (via implied volatility) expects. If you had a directional view, a single call or put would be more efficient — the straddle pays for optionality in both directions.
Question 4 True / False
In a bull call spread, selling the higher-strike call reduces the net premium paid but limits the maximum profit the strategy can generate.
TTrue
FFalse
Answer: True
This is the fundamental spread tradeoff. The premium received from selling the upper-strike call reduces net cost, lowering the break-even point and capital at risk. But by selling that call, you are obligated to deliver if the stock exceeds the upper strike. Any gain on the long lower-strike call above the upper strike is exactly offset by the loss on the short upper-strike call. Maximum profit is capped at (K₂ − K₁) minus net premium paid.
Question 5 Short Answer
Describe the three positions that constitute a collar and explain the economic tradeoff it represents for an equity holder.
Think about your answer, then reveal below.
Model answer: A collar involves: (1) holding the underlying stock, (2) buying a put option below the current price to establish a floor on losses, and (3) selling a call option above the current price, using the premium received to offset the put's cost. The tradeoff is that you give up upside participation above the call strike in exchange for downside protection below the put strike. If strikes are chosen so call premium ≈ put premium, the collar can be structured at near-zero net cost.
Collars are popular for hedging large equity positions (e.g., an executive with concentrated company stock) because they provide meaningful protection at low net cost. The payoff diagram of the combined position shows a horizontal line below the put strike (loss is floored), a rising diagonal between the strikes, and another horizontal line above the call strike (gain is capped). The collar converts unlimited upside and unlimited downside into a bounded range of outcomes.