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i p s o r e r i e s 7 p t i o n s u e s t i o n s

February 15, 2012 | Filed Under Professional Education, Series 7

In the Series 7 exam, questions about options tend to be one of the biggest challenges

for test takers. This is because options questions make up a large part of the exam

and many candidates have never been exposed to options contracts and strategies.

(To read more about the Series 7, see Solving Mixed Options Problems On The Series

7.)

In this article we'll give you a detailed description of the world of options contracts as

well as the strategies associated with them. Our test-taking tips will put you in a

position to ace this portion of the Series 7 exam and increase your chances of getting a

passing score. (For everything you need to know for the Series 7 exam, see our Free

Series 7 Online Study Guide.)

See: Options Basics

Options Questions

By most estimates, there are about 50 questions on options on the Series 7 exam,

approximately 35 of which are questions that deal with options strategies. The

remaining 15 questions are options markets, rules and suitability questions. Because

most of the questions focus on options strategies, we'll concentrate on those.

In the Series 7 exam, questions about options strategies concentrate on:

Puts

Calls

Straddles

Spreads

Hedges

Covered contracts

However, the scope of the questions tends to be limited to:

Maximum gain

Maximum loss

Breakeven

Expected direction of stock movement for profit (up/down, bullish/bearish)

(For background reading, check out Option Spread Strategies.)


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The Basics

It Takes Two to Make a ContractRemember the word contract. There are two parties in a contract. When one party

gains a dollar, the other party loses a dollar. For that reason, the buyer and the seller

reach the breakeven point at the same time. When the buyer has regained all of the

premium money spent, the seller has lost the entire premium they received. This

situation is called a zero-sum game: for every person who gains on a contract, there is

a counterparty that loses.

Most Options Contracts Are Not Exercised

The majority of options investors are not interested in buying or selling stock. They are

interested in profits from trading the contracts themselves. In one sense, the options

exchanges are much like horse racing tracks. While there are people there who plan to

buy or sell a horse, most of the crowd is there to bet on the race. Pay very close

attention to the concepts of opening and closing options contract positions and don't

be locked into the idea ofexercising contracts.

Terminology Tangles

Notice in Figure 1 - which we'll call the "matrix" - that the term "buy," can be replaced

by the terms "long" or "hold." The term "sell" can be replaced by the terms "short" or

"write." The exam will frequently interchange these terms, often in the same question.

Write the matrix down your scratch paper before starting the exam and refer to it

frequently to help keep you on track.


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Figure 1

Buyers' Rights, Sellers' Obligations

If you look at Figure 1, you'll notice that buyers have all the rights; they've paid a

premium for the rights. Sellers have all the obligations; they've received a premium for

taking the obligation (risk). You can think of an options contract like a car insurance

contract: the buyer pays the premium and has the right to exercise; they and can lose

no more than the premium paid. The seller has the obligation to perform when and if

called upon by the buyer; the most the seller can gain is the premium received. Applythese ideas to options contracts. (To read more on this concept, see The Four

Advantages Of Options and Reducing Risk With Options.)

Question "Call Up and Put Down"Many people have been misled by the old saying, "call up and put down." The problem

is that this is only half right. It's true for the buy (or long) side, but it is not true of the

sell side. On the short, or sell side, things are exactly opposite in that you could profit

from an increase in the asset underlying a put option if you have shorted a put. (For


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related reading, see Prices Plunging? Buy A Put!and Going Long On Calls.)

Time Value for Buyers and Sellers

Because an option has a definite expiration date, the time value of the contract is often

called a wasting asset. Remember: Buyers always want the contract to be exercisable.

They may never exercise ((they will probably sell the contract (closing it) for a profit

instead)), but they want to be able to exercise. Sellers, on the other hand, want the

contract to expire worthless because this is the only way that the seller (short) can

keep the entire premium (the maximum gain to sellers). (To read more, check out The

Importance Of Time Value In Options Trading.)

Four No-Fail Steps to Follow

One of the problems that Series 7 candidates report when working on options

problems, is that they are not sure of how to approach the questions. There is a four-

step process that is usually helpful:

1. Identify the strategy2. Identify the position

3. Use the matrix to verify desired movement

4. Follow the dollars

All four of these steps may not be necessary for each and every options problem. If,

however, you use the process in the more complex situations, you'll find that these

steps greatly simplify the problem.

Let's use the four steps outlined above in some examples.

The first formula a Series 7 candidate should remember is for the options premium:

Premium = Intrinsic Value + Time Value

Question: An investor is long 1 XYZ December 40 call at 3. Just prior to the close of

the market on the final trading day before expiration, XYZ stock is trading at 47. The

investor closes the contract. What is the gain or loss to the investor?

First, let's use the four-step process:

1. Identify the strategy -A call contract

2. Identify the position - long = buy = hold(has the right to exercise)

3. Use the matrix to verify desired movement - bullish, wants the market to rise

4. Follow the dollars - Make a list of dollars in out:

$ Out $ In


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- -

- -

- -

Answer:

Questions in the exam may refer to a situation in which a contract is "trading on its

intrinsic value." The phrase, "just prior to the close of the market on the final tradingday before expiration" means that there is no time value, and, therefore, the premium

is made up entirely of intrinsic value.(For related reading, see How To Avoid Closing

Options Below Intrinsic Value.)

Because the investor is long the contract, they have paid a premium. The problem

states that the investor closes the position. If an options investor buys to close the

position, the investor will sell the contract, offsetting the open long position. This

investor will sell the contract for its intrinsic value because there is no time value

remaining. Because the investor bought for three ($300) and sells for the intrinsic valueof seven ($700), they will have a $400 profit.

How can you arrive at the intrinsic value so easily? Look at Figure 2, the intrinsic value

chart. If the contract is a call and the market is above the strike (exercise) price, the

contract is in the money - it has an intrinsic value. Put contracts operate in exactly the

opposite direction.


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Figure 2

One cautionary note: The contract itself is in or out of the money, but this does not

necessarily translate into a profit or loss for a particular investor. Buyers want the

contracts to be in the money (have an intrinsic value). Sellers want contracts to be out

of the money (no intrinsic value).

Formulas for Calls

Long Calls:

Maximum Gain = Unlimited

Maximum Loss = Premium paid

Breakeven = Strike price + Premium

Short Calls:

Maximum Gain = Premium Received

Maximum Loss = Unlimited

Breakeven = Strike Price + Premium


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Refer again to Figure 1 and remember that whenever the buyer gains a dollar, the seller

loses a dollar. Call buyers are bullish; call sellers are bearish. Look at the formulas:

Simply swap the gains and losses and remember that both parties to the contract

break even at the same point.

Formulas for Puts

Long Puts:

Maximum Gain = Strike Price - Premium x 100

Maximum Loss = Premium Paid

Breakeven = Strike Price - Premium

Short Puts:

Maximum Gain = Premium received

Maximum Loss = Strike Price - Premium x 100

Breakeven = Strike Price - Premium

Note that in Figure 1, the buyers of puts are bearish. The market value of the

underlying stock must drop below the strike price (go in the money) enough to recover

the premium for the contract holder (buyer, long). The maximum gains and losses are

expressed as dollars. So to find that amount, we multiply the breakeven price by 100.

If the breakeven point is 37, multiply by 100 to get the maximum possible gain for the

buyer: $3,700. The maximum loss to the seller will also be $3,700.

Straddle Strategies and Breakeven Points

Questions regarding straddles on the Series 7 tend to be limited in scope. Primarilythey focus on straddle strategies and the fact that there are always two breakeven

points.

Step 1 and 2:

The first item on your agenda when you see any multiple options strategy on the

exam, is to identify the strategy. This is where the matrix in Figure 1 becomes a useful

tool. If an investor, for example, is buying a call and a put on the same stock with the

same expiration and the same strike, the strategy is a straddle.

Look back at Figure 1. If you look at buying a call and buying a put, an imaginary loop

around those positions is a straddle - in fact, it is a long straddle. If the investor is

selling a call and selling a put on the same stock with the same expiration and the same

strike price, it is a short straddle.

If you look closely at the arrows within the loop on the long straddle in Figure 1, you'll

notice that the arrows are moving away from each other. This is a reminder that the

investor who has a long straddle expects volatility. Look now at the arrows within the


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loop on the short straddle; they are coming together. This is a reminder that the short

straddle investor expects little or no movement. These are the essential straddle

strategies.

Step 3 and 4:

By looking at the long or short position on the matrix, you've completed the second

part of the four-part process. Because you are using the matrix for the initial

identification, skip to step four.

In a straddle, investors are either buying two contracts or selling two contracts. To find

the breakeven, add the two premiums and then add the total of the premiums to the

strike price for the breakeven on the call contract side. Subtract the total from the

strike price for the breakeven on the put contract side. A straddle always has two

breakevens.

Example - Straddle

Let's look at an example. An investor buys 1 XYZ November 50 call @ 4 and is long 1XYZ November 50 put @ 3. At what points will the investor break even?

Hint: Once you've identified a straddle, write the two contracts out on your scratch

paper with the call contract above the put contract. This makes the process easier to

visualize.

Like this:

Figure 3


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Instead of clearly asking for the two breakeven points, the question may ask: between

what two prices will the investor have a loss? If you're dealing with a long straddle, the

investor must hit the breakeven point to recover the premium. Movement above or

below the breakeven point will be profit. Notice that the arrows in the problem

illustrated above match the arrows within the loop for a long straddle. The investor in a

long straddle is expecting volatility.

Note: Because the investor in a long straddle expects volatility, the maximum loss

would occur if the stock price were to be exactly the same as the strike price (at the

money) - neither contract would have any intrinsic value. Of course, the investor with a

short straddle would like the market price to close at the money to keep all the

premiums. In a short straddle, everything is reversed.

Long Straddles:

Maximum gain: Unlimited (the investor is long a call)

Maximum loss: Both premiums

Breakeven: Add the sum of both premiums to the call strike price and subtract

the sum from the put strike price

Short Straddles:

Maximum gain: Both premiums

Maximum loss: Unlimited (short a call)

Breakeven: Add the sum of both premiums to the call strike price and subtract

the sum from the put strike price

Beware of Combination Straddles

If, in the identification process, you see that the investor has bought (or sold) a call

and a put on the same stock but the expiration dates are different and/or the strike

prices are different, the strategy is a combination. If asked, the calculation of the

breakevens is the same, and the same general strategies - volatility or no movement -

apply.

SpreadsSpread strategies seem to be the most difficult for many Series 7 candidates. By using

the tools we have already discussed and some acronyms that will help in remembering

different spread objectives, we'll simplify spreads.

Let's use the four-step process to solve the following problem:

Write 1 ABC January 60 call @ 2


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Long 1 ABC January 50 call @ 8

1.Identify the Strategy:

A spread is defined as an investor being long and short the same type of options

contracts (calls or puts) with differing expirations, strike prices or both.

If only the strike prices are different, it is a price or vertical spread. If only the

expirations are different, it is a calendar spread (also known as a "time" or "horizontal"

spread). If both the strike price and expirations are different, it is a diagonal spread. All

of these terms refer to the layout of options quotes in the newspapers. The strategy

laid out above is a call spread. Technically, it is a vertical call spread. (To read more, see

Vertical Bull And Bear Credit Spreads.)

2.Identify the Position:

In spread strategies, the investor is a buyer or a seller. When you determine the

position, look at the block in the matrix that illustrates that position and keep your

attention on that block alone. At this point, we need to address the idea of debitversus credit. If the investor has paid out more than they have received, it is a debit

(DR) spread. If the investor has received more in premiums than they have paid out, it

is a credit (CR) spread. These terms are critical to answering spread questions.

Here, there is one additional qualifier to the complete description of the spread. We can

now call it a debit call spread. The spread has been established at a net debit of $600.

The investor is, in net terms, a buyer of call contracts. Look at the matrix: buyers of

calls are bullish. This is, then, a bull or debit call spread. The investor is anticipating a

rising market in the stock.

3. Check the Matrix:

Actually, we could have used the matrix to identify the strategy as a spread. If you look

at the matrix and see that the two positions are inside the horizontal loop on the

matrix, the strategy is a spread.

4. Follow the Dollars:

(DR) (CR)

$Out $In

$800 $200

$600

Tip: It may be helpful to write the $Out/$In cross directly below the matrix so that the

vertical bar is exactly below the vertical line dividing buy and sell. That way, the buying

side of the matrix will be directly above the DR and the selling side of the matrix will be

exactly above the CR side.


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Tip: Notice that in the example, the higher strike price is written above the lower strike

price. Once you've identified a spread, write the two contracts on your scratch paper

with the higher strike price above the lower strike price. This makes it much easier to

visualize the movement of the underlying stock between the strike prices.

The maximum gain for the buyer; loss for the seller and the breakeven for both will

always be between the strike prices.

Formulas and Acronyms for Spreads

Debit (Bull) Call Spreads:

Maximum Loss: Net Premium Paid

Maximum Gain: Difference in Strike Prices - Net Premium

Breakeven: Lower Strike Price + Net Premium

Credit (Bear) Call Spreads:

Maximum Loss: Difference in Strike Prices - Net Premium

Maximum Gain: Net Premium Received

Breakeven: Lower Strike Price + Net Premium

Tip: For breakevens, an acronym some candidates find helpful is CAL - In a Call spread

Add the net premium to the Lower strike price.

Using the above example of a bull or DR call spread:

Maximum loss: $600 - the net premium. If ABC stock does not rise above 50, the

contract will expire worthless and the bullish investor loses the entire premium.

Maximum Gain: Use the formula:

Difference in Strike Prices - Net Premium

(60-50) - 6 = 10 - 6 =4 x 100 = $400

Breakeven: Since this is a call spread, we will add the net premium to the lower

strike price. 6 + 50 = 56. The stock must rise to at least 56 for this investor to

recover the premium paid.



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Maximum gain = 4

Breakeven point: 56

Movement of ABC stock = +6

Difference in strike prices = 10

Notice that when the stock has risen by six points to the breakeven point, the investormay only gain four points of profit ($400). Notice that 6 + 4 = 10 - the number of

points between the strike prices.

Tip: Above 60, the investor has no gain or loss. Remember when an investor sells or

writes an option, they are obligated. This investor has the right to purchase at 50 and

the obligation to deliver at 60. Be very careful to remember the rights and obligations

when solving spread problems.

There are other, very frequently reported questions about spreads. Referring again to

the example:



To profit from this position, the spread in premiums must:

A. Narrow

B. Widen

C. Stay the same

D. Invert

Tip: The first point of simplification is this: In any question of this nature regarding

spreads, the answer will always be widen or narrow. Eliminate C and D.

Use the acronym DEW, which stands for Debit/Exercise/Widen. Once you've identified

the strategy as a spread and identified the position as a debit, the investor expects the

difference between the premiums to widen. Remember: buyers want to be able toexercise.

If the investor has created a credit spread, use the acronym CVN, which stands for

Credit/Valueless/Narrow. Sellers, those in a credit position, want the contracts to

expire valueless (no intrinsic value, worthless) and the spread in premiums to narrow.

Formulas for Put Spreads

Debit (Bear) Put Spread:


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Maximum gain: Difference in Strike Prices - Net Premium

Maximum loss: Net Premium

Breakeven: Higher Strike Price - Net Premium

Credit (Bull) Put Spread:

Maximum gain: Net Premium

Maximum loss: Difference in Strike Prices - Net PremiumBreakeven: Higher Strike Price - Net Premium

Tip: For breakevens, an acronym some candidates find helpful is PSH - In a Put spread

Subtract the net premium from the Higher strike price.

Spreads may require more steps for a solution, but if you use the shortcuts, solving

the problem is much simpler.

The Bottom Line

Options contracts questions in the Series 7 exam are numerous, but the scope of the

questions is limited. If you use the four-step process, you can dramatically increase

your chances of getting a passing score. To get the hang of it, you'll have to practice

as many questions on options as possible before to taking the exam. Good luck! (For

everything you need to know for the Series 7 exam, see our Free Series 7 Online Study

Guide.)

by In v e s to p e d ia S ta f f

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