DFOL: Option Strategy Risk and Reward

Topic snapshot

Option-strategy checklist before the questions

Strategy questions test the combined payoff, not the label. Break the position into legs, then identify market view, maximum gain, maximum loss, breakeven, margin impact, and assignment risk.

• Covered calls, protective puts, spreads, straddles, and combinations all change upside, downside, and income differently.
• A lower-cost strategy can still create the wrong risk for the client.
• Short-option legs deserve extra attention because obligations can dominate the payoff.

What to drill next after strategy misses

If you miss these questions, list each leg and its payoff before reading the explanation. Then drill option-account questions because many strategy errors are also approval, margin, or suitability errors.

Sample questions

These questions are original Securities Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Option Strategy Risk and Reward

Shares of a TSX-listed company are trading at $50.00 just before earnings. A client expects a sharp move but has no directional view and is considering a long 50 straddle or a long 45-55 strangle with the same expiry. Ignore commissions.

Exhibit:

• 50 call: $2.50
• 50 put: $2.50
• 55 call: $1.00
• 45 put: $1.00

Which interpretation is most accurate?

• A. Both strategies are most attractive when low volatility and rapid time decay are expected.
• B. A long straddle is a volatility trade with closer breakevens; a long strangle is cheaper but needs a larger move.
• C. Straddles are mainly bullish, while strangles are mainly bearish.
• D. Because it costs less, the long strangle needs a smaller move to profit.

Best answer: B

What this tests: Option Strategy Risk and Reward

Explanation: Long straddles and long strangles are chosen for expected volatility, not for a simple up-or-down view. The straddle costs more but has closer breakevens, while the strangle costs less upfront but requires a larger move before it becomes profitable.

A long straddle and a long strangle are both long-volatility strategies. The buyer does not need to predict direction correctly; the buyer needs the stock to move far enough away from the current price so that intrinsic value exceeds total premium paid.

Here, the 50 straddle costs $5.00, so its breakevens are $45 and $55. The 45-55 strangle costs $2.00, so its breakevens are $43 and $57.

• The straddle uses at-the-money options, so it costs more.
• The strangle uses out-of-the-money options, so it costs less.
• The lower-cost strangle is not easier to profit from; it needs a bigger price swing.

The key takeaway is that attractiveness depends on expected move size and volatility relative to premium, not on being bullish or bearish.

• Directional mistake both strategies can profit from a large move in either direction, so neither is mainly bullish or mainly bearish.
• Cheaper not easier the strangle’s lower premium is offset by wider strikes, so its breakevens are farther away.
• Theta misunderstanding low volatility and fast time decay generally help option writers, not buyers of straddles or strangles.

The straddle breaks even at $45 and $55, while the cheaper strangle breaks even farther out at $43 and $57.

Question 2

Topic: Option Strategy Risk and Reward

A client buys an at-the-money call and an at-the-money put on the same Toronto-listed stock, with the same strike and expiry, because she expects implied volatility to rise before earnings. Two days later, the share price is still near the strike, but implied volatility has dropped sharply. Which option sensitivity captures the primary risk that hurt this position?

• A. Delta, sensitivity to small stock price changes
• B. Gamma, sensitivity of delta to stock price changes
• C. Theta, sensitivity to the passage of time
• D. Vega, sensitivity to implied volatility changes

Best answer: D

What this tests: Option Strategy Risk and Reward

Explanation: This is a long straddle, which is typically long vega. Because the stock stayed near the strike and implied volatility fell sharply, volatility exposure was the main reason the position lost value.

A long straddle is often used when an investor expects a large move or wants exposure to higher implied volatility. In this scenario, the share price stayed near the strike, so the loss was not mainly driven by direction. The stem specifically says implied volatility dropped sharply, and vega measures how much an option’s price changes when implied volatility changes.

Long options generally have positive vega, so both the call and the put tend to lose value when implied volatility falls. Theta is also a normal cost of holding a long straddle, but the question asks for the primary risk that mattered most under these facts. The key takeaway is that vega is the main sensitivity for a volatility-driven long option position.

• Time decay matters for a long straddle, but the stem points to volatility contraction as the main driver of the loss.
• Directional exposure is not the main issue because the stock remained near the strike.
• Changing delta becomes important after a meaningful price move, which did not occur here.

A long at-the-money straddle is long vega, so a sharp drop in implied volatility reduces the value of both options.

Question 3

Topic: Option Strategy Risk and Reward

A client sells an at-the-money listed call and an at-the-money listed put on the same Canadian stock, with the same strike price and expiry, because she expects the shares to stay near the strike and implied volatility to decline over the next month. What is the primary risk/tradeoff of this short-volatility strategy?

• A. The position needs rising volatility and a big move to profit.
• B. Time decay hurts the position if the stock stays near the strike.
• C. Large price swings can cause losses far above premiums received.
• D. Maximum loss is limited to the total premium collected.

Best answer: C

What this tests: Option Strategy Risk and Reward

Explanation: This is a short straddle, which is a short-volatility strategy. It works best when the underlying stays near the strike and volatility falls, but the tradeoff is limited profit versus potentially very large losses if the stock moves sharply up or down.

A short straddle is created by selling a call and a put with the same strike and expiry. It is a classic short-volatility position because the seller wants the stock to stay relatively stable and implied volatility to fall. The maximum gain is limited to the total premium received, so the upside is capped from the start.

The main risk is a large move in either direction:

• If the stock rises sharply, the short call can generate substantial losses.
• If the stock falls sharply, the short put can generate substantial losses.
• If implied volatility rises, the position usually becomes more expensive to close.

So the key tradeoff is limited income in exchange for exposure to potentially very large losses from unexpected volatility or directional movement.

• The idea that the trade needs rising volatility and a big move describes a long-volatility strategy such as a long straddle.
• The claim that loss is limited to premium collected reverses the payoff profile; limited loss applies to buying options, not selling this combination.
• The statement about time decay hurting the position is backwards, because time decay generally helps a short option position when price stays near the strike.

A short straddle benefits from stability, but a sharp move in either direction can create very large losses while profit is limited to the premium collected.

Question 4

Topic: Option Strategy Risk and Reward

A retail client owns 300 shares of a TSX-listed company trading at $52. She is moderately bullish over the next three months, wants to keep the shares, and wants downside protection near $48 without capping her upside. Her account is approved for stock and long listed options only. Which strategy best meets her objective?

• A. Sell the 300 shares and buy 3 $52 call contracts
• B. Buy 3 $48 puts and sell 3 $56 calls against the shares
• C. Buy 3 $48 put contracts against the 300 shares
• D. Sell 3 $56 call contracts against the 300 shares

Best answer: C

What this tests: Option Strategy Risk and Reward

Explanation: A married put combines long stock with a long put on the same shares. The put creates a minimum value near its strike price, so the investor keeps upside in the stock while limiting downside to the gap between the stock price and strike, plus the premium.

A married put, also called a protective put, changes a long stock position from having substantial downside exposure to having defined downside protection for the life of the option. The investor still owns the shares, so gains above the current price remain available. At the same time, the long put gains value as the stock falls below the strike, offsetting further losses on the shares.

Here, buying 3 put contracts with a $48 strike on 300 owned shares sets a floor near $48 for three months. Relative to a current stock price of $52, the downside is limited to roughly $4 per share plus the put premium, while upside remains open. A strategy that includes a short call may also reduce risk, but it would cap gains and does not match the stated objective.

• Covered call generates premium but leaves most stock downside intact and can cap gains.
• Collar adds downside protection, but the short call caps upside and requires option-writing approval.
• Sell stock, buy calls limits risk, but it no longer hedges an existing long stock position because the shares are gone.

Buying the $48 puts creates a married put, which keeps stock upside while placing a downside floor near the put strike, net of premium.

Question 5

Topic: Option Strategy Risk and Reward

A client with an approved listed-options account buys an at-the-money long straddle on a Bourse de Montreal-listed ETF option. She has no directional view, expects volatility to rise before a major Bank of Canada announcement, and wants her maximum loss limited to the premiums paid. She asks which option sensitivity best indicates how the straddle’s value should change if implied volatility rises before expiry. Which sensitivity is most relevant?

• A. Theta
• B. Gamma
• C. Delta
• D. Vega

Best answer: D

What this tests: Option Strategy Risk and Reward

Explanation: Vega is the basic option sensitivity that measures exposure to changes in implied volatility. Because a long straddle is primarily a volatility strategy with loss limited to the premiums paid, rising implied volatility would generally help the position, all else equal.

This question tests the broad meaning of the main option sensitivities. A long straddle combines a long call and a long put with the same strike price and expiry, so it is commonly used when an investor expects a large move but is unsure of direction. If the focus is specifically on how the position responds to a change in implied volatility before expiry, the key sensitivity is vega. Higher implied volatility tends to increase both option premiums, which usually benefits a long straddle. Delta measures sensitivity to changes in the underlying price, gamma measures how quickly delta changes as the underlying moves, and theta measures the effect of time passing. When the issue is volatility repricing rather than direction or time decay, vega is the best measure.

• The option naming delta is about sensitivity to the underlying price, so it does not directly answer a volatility question.
• The option naming gamma measures the rate of change of delta, which matters when the underlying moves, not for direct implied-volatility exposure.
• The option naming theta measures time decay; for a long straddle, time passing is usually a cost rather than the relevant sensitivity here.

Vega measures the change in an option position’s value for a change in implied volatility.

Question 6

Topic: Option Strategy Risk and Reward

A retail client with an approved option account has already received the options risk disclosure. She wants to buy a long straddle on a TSX-listed bank stock before earnings. The representative notes that implied volatility is unusually high, making both the call and put expensive. The client expects a large move but has no view on direction. What is the best next step?

• A. Ignore volatility and assess only whether the stock may finish above the strike.
• B. Recommend selling the straddle because rich premiums make the trade safer.
• C. Compare her expected move with the volatility already priced into the premiums.
• D. Enter the long straddle because a direction-neutral view is sufficient.

Best answer: C

What this tests: Option Strategy Risk and Reward

Explanation: Volatility in options refers to the expected size of price movement, not the direction. Because higher implied volatility raises both call and put premiums, the representative should first assess whether the client’s expected move is greater than what the market has already priced in.

The core concept is that implied volatility affects option prices before expiry. When implied volatility is high, both calls and puts become more expensive because the market expects a larger possible move. A long straddle is a long-volatility strategy: it fits a client who expects a big move in either direction, but it is most attractive when the actual move is likely to exceed the move implied by the premiums.

In this case, the representative should first test whether the client’s forecast justifies paying those elevated option prices. If volatility is already richly priced, buying the straddle may still lose money even if the stock moves. The closest mistake is assuming that a non-directional view alone is enough; the cost of volatility matters just as much.

• Immediate entry skips the key suitability step of comparing the client’s expected move with the expensive premiums.
• Selling the straddle changes to a short-volatility strategy with substantial risk, not a safer version of the same idea.
• Ignoring volatility is incorrect because volatility directly affects option pricing, not just the stock’s final position versus the strike.

A long straddle is a long-volatility strategy, so the key next step is deciding whether the expected move is large enough to overcome elevated implied volatility.

Question 7

Topic: Option Strategy Risk and Reward

All amounts are in CAD. NorthRiver Energy shares trade at $40. A client expects a major move after a regulatory ruling but is unsure of direction, so she buys one listed 40 call for $2.40 and one listed 40 put for $2.10 on the Bourse de Montreal, both expiring in one month. Later the same day, the shares are still $40, but implied volatility on both options rises sharply. Which statement best interprets the position?

• A. It will usually gain value because higher volatility increases both options’ time value.
• B. Only the call should gain value from greater uncertainty.
• C. It should be unchanged because neither option has intrinsic value.
• D. It should lose value because long straddles prefer lower volatility.

Best answer: A

What this tests: Option Strategy Risk and Reward

Explanation: Buying the at-the-money call and put creates a long straddle. With the share price still at $40, intrinsic value is unchanged, but a sharp rise in implied volatility usually increases the time value of both long options.

The position is a long straddle: a long call and a long put with the same strike and expiry. Traders use this strategy when they expect a large move but do not know the direction. Because the shares are still at $40, the options have not gained additional intrinsic value, so the main change comes from time value. A long straddle is typically positive vega, meaning a rise in implied volatility usually increases the premiums of both options.

That is why the position can become more valuable even before the stock actually moves.

• Intrinsic value only misses that option premiums also include time value, which usually rises when implied volatility rises.
• Wrong volatility view reverses the exposure; long straddles generally benefit from rising implied volatility, not falling implied volatility.
• Call-only effect is incorrect because greater uncertainty usually lifts both the long call and the long put.

A long straddle is positive vega, so a rise in implied volatility generally increases the value of both long options.

Question 8

Topic: Option Strategy Risk and Reward

All amounts are in CAD. A client established the following bullish position today and asks how the put changes the risk of holding the shares, ignoring commissions.

Exhibit: Position snapshot

Underlying: NSE Ltd.
Current share price: \$48.20
Long stock: 500 shares
Long puts: 5 June 47 contracts at \$1.10
Contract size: 100 shares

Which interpretation is best supported by the exhibit?

• A. The puts only hedge 400 shares, so 100 shares remain unprotected.
• B. The puts cap stock gains once NSE rises above $47.
• C. The puts remove all downside risk for as long as the shares are held.
• D. The puts fully hedge 500 shares through June expiry and limit downside to about $2.30 per share, while upside stays open.

Best answer: D

What this tests: Option Strategy Risk and Reward

Explanation: A married put combines long stock with a long put on the same number of shares. Here, five puts cover all 500 shares, so the client has downside protection through June expiry: from today’s entry, loss is limited to about $2.30 per share, while gains can still increase if the stock rises.

A married put, also called a protective put, keeps the bullish exposure of owning the shares but adds insurance against a sharp decline. Because the client bought 5 put contracts and each contract covers 100 shares, the entire 500-share position is protected. The 47 strike is the minimum sale price available before the June expiry, so the stock’s downside is no longer open-ended during that period.

If the shares rise, the stock still participates in that upside; the only cost of the insurance is the 1.10 premium. The key takeaway is that a married put limits downside without capping upside, but only until the put expires.

• Partial hedge fails because 5 contracts at 100 shares each protect all 500 shares.
• Permanent protection fails because the floor exists only until June expiry, and the position can still lose 2.30 per share from today’s entry.
• Capped upside confuses a married put with a covered call; a long put does not limit gains on the stock.

Five 100-share puts cover all 500 shares, and the 47 strike sets a floor through June, limiting loss from today’s entry to about 2.30 per share.

Question 9

Topic: Option Strategy Risk and Reward

A client wants a bearish position in Prairie Data Inc. but does not want unlimited loss if the shares rise. Ignore commissions, stock-borrow costs, and dividends.

Exhibit: Order ticket

Underlying: Prairie Data Inc.
Stock trade: Sell short 1,000 shares @ \$48.00
Option trade: Buy 10 Dec 50 calls @ \$2.30
Contract size: 100 shares per call
Account: Margin

Which interpretation is best supported by the exhibit?

• A. The long calls cap the maximum gain at $4.30 per share.
• B. The position breaks even when the stock reaches $50.00.
• C. The long calls cap the maximum loss at $4.30 per share.
• D. The position still has unlimited loss if the stock rises.

Best answer: C

What this tests: Option Strategy Risk and Reward

Explanation: This is a protected short sale: short stock plus a long call on the same shares. The call limits the repurchase price to the strike, so the unlimited upside risk of the short sale is capped at \(50 - 48 + 2.30 = 4.30\) per share.

A protected short sale combines a bearish short stock position with a long call on the same underlying. The long call changes the risk profile because, if the stock rises sharply, the trader can acquire shares at the call strike instead of facing unlimited market buy-back risk.

So the position remains bearish, but its upside risk is capped and its downside profit is reduced by the call premium. The closest trap is treating the strike as break-even; break-even is $45.70, not $50.00.

• Gain capped reverses the logic; $4.30 is the worst loss, not the best possible gain.
• Unlimited loss ignores the purchased calls, which cover all 1,000 short shares at the $50 strike.
• Strike as break-even confuses exercise price with net cost; the call premium lowers break-even to $45.70.

The long call lets the short seller buy at $50, so the worst loss is \(50 - 48 + 2.30 = 4.30\) per share.

Question 10

Topic: Option Strategy Risk and Reward

Maple Bank shares are trading at $50.00. A client reviews two Bourse de Montreal-listed positions:

• Position 1: Buy 1 October 50 call and sell 1 July 50 call
• Position 2: Buy 1 July 50 call and buy 1 July 50 put

Which statement best interprets these positions?

• A. Both positions mainly profit if the shares stay near $50 through July.
• B. Position 1 targets a large move by July; Position 2 targets differing time decay.
• C. Position 1 targets differing time decay; Position 2 targets a large move by July.
• D. Both positions are bullish because each contains a long call.

Best answer: C

What this tests: Option Strategy Risk and Reward

Explanation: Position 1 is a long calendar spread because it uses the same strike with different expiry months. Position 2 is a long straddle because it uses a call and put with the same July expiry, so it mainly benefits from a big move in either direction.

The key distinction is the option dates. Position 1 uses different expiries at the same strike, which makes it a calendar-style timing trade. Its value is driven largely by the faster time decay of the short-dated July call relative to the longer-dated October call. Position 2 uses the same July expiry for both a call and a put at the same strike, which makes it a same-expiration volatility trade. A long straddle generally needs a meaningful price move before July expiry to overcome the premiums paid. The easiest way to separate these strategies is to check whether the expiries differ or match.

• Reversing the profiles fails because different expiry months point to a calendar spread, not a same-expiration volatility position.
• Saying both positions want the shares near $50 ignores that the long straddle usually needs a sizable move.
• Calling both positions bullish ignores the long put in the straddle and the timing focus of the calendar spread.

Different expiry months make Position 1 a calendar-style timing trade, while the same-expiration call and put in Position 2 create a volatility trade.

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Related focused pages

• Free DFOL Full-Length Practice Exam
• DFOL: An Overview of Derivatives
• DFOL: Futures Contracts
• DFOL: Exchange Traded Options
• DFOL: Swaps
• DFOL: Fund and Structured Product Derivatives
• DFOL: Opening and Maintaining Option Accounts
• DFOL: Clearing Corporations and Options Exchanges
• DFOL: Contract Adjustments and Non-Equity Option Risks

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