Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksHard
A financial advisor is explaining the features of derivatives to a new client. When discussing call options, which statement accurately describes the maximum potential loss for the buyer of a call option?
- AThe premium paid for the option.
- BThe strike price plus the premium paid.
- CUnlimited, as the underlying asset can fall to zero.
- DThe market price of the underlying asset.
Show answer & explanationAnswer & explanation
Correct answer: A. The premium paid for the option.
The maximum loss for the buyer of a call option is limited to the premium paid. If the underlying asset's price does not rise above the strike price plus premium, the option will expire worthless, and the buyer will lose only the initial premium.
Why the other options are wrong
- B. This is not the maximum loss; it includes the strike price which is not lost by the buyer.
- C. Unlimited loss is characteristic of selling (writing) uncovered options, not buying them.
- D. The market price of the underlying asset is irrelevant to the maximum loss for an option buyer.
Maximum Loss for Call Option Buyer
The greatest amount of money a buyer of a call option can lose, which is limited to the premium paid for the option.
- Premium is the upfront cost of the option
- Occurs if the option expires out-of-the-money
- Buyers of options have limited risk
- Contrast with sellers (writers) who can have unlimited risk (uncovered)
Memory trick: Call Buyer's Loss: Just the PREmium, that's the PREvention.