Question

You own a stock portfolio worth $50,000. You are worried that stock prices may take a dip before you are ready to sell, so you are considering purchasing either at-the-money or out-of-the-money puts. If you decide to purchase the out-of-the-money puts, your maximum loss is __________ than if you buy at-the-money puts and your maximum gain is __________.

Answer 1

Question Completion:

A) greater; lower

B) greater; greater

C) lower; greater

D) lower; lower

Answer:

B) greater; greater

Explanation:

The underlying put option for your stock portfolio of $50,000 is in the money (ITM) when you can sell the underlying security above its current market price.  The buyer's hope is that the stock's price will fall below the option's strike price to ensure coverage of the premium cost for buying the put.  If you buy at the money (ATM), the option's strike price is identical to the price of the underlying security.  But if you buy out of the money (OTM), it means that the underlying security's price is above the strike price.  In conclusion, OTM options are less expensive than ITM or ATM options.