Tips for Answering Series 7 Options Questions

The Answer

Questions in the exam may refer to a situation in which a contract is “trading on its intrinsic value,” which is the perceived or calculated value of a company, using fundamental analysis. The intrinsic value, which may or may not be the same as the current market value, indicates the amount that an option is in-the-money. It is important to note that buyers want the contracts to be in-the-money (have intrinsic value), while sellers want contracts to be out-of-the-money (have no intrinsic value).

In the problem, because the investor is long the contract, they have paid a premium. The problem likewise states that the investor closes the position. An options investor who buys to close the position will sell the contract, offsetting the open long position. This investor will then sell the contract for its intrinsic value because there is no time value remaining. And because the investor bought for three ($300) and sells for the intrinsic value of seven ($700), he would lock in a $400 profit.

By examining Figure 2, entitled “Intrinsic Value”, it’s clear that the contract is a call and that the market is above the strike (exercise) price, and that the contract is in-the-money, where it has an intrinsic value. Conversely, the put contracts operate in the opposite direction.

Formulas for Call Options

Long Calls:

• The maximum gain = unlimited
• Maximum loss = premium paid
• Breakeven = strike price + premium

Short Calls:

• The maximum gain = premium received
• Maximum loss = unlimited
• Breakeven = strike price + premium

Formulas for Put Options

Long Puts:

• The maximum gain = strike price – premium x 100
• Maximum loss = premium paid
• Breakeven = strike price – premium

Short Puts:

• The maximum gain = premium received
• Maximum loss = strike price – premium x 100
• Breakeven = strike price – premium

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.

Therefore, to determine that amount, simply multiply the breakeven price by 100. For example, if the breakeven point is 37, the maximum possible gain for the buyer is $3,700, while the maximum loss to the seller is that same amount.

Straddle Strategies and Breakeven

Questions regarding straddles on the Series 7 tend to be limited in scope, primarily focusing on straddle strategies and the fact there are always two breakeven points.

Steps 1 and 2

The first step 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. For example, If an investor is buying a call and a put on the same stock with the same expiration and the same strike, the strategy is a straddle.

Consult 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 the arrows are moving away from each other. This is a reminder that the investor who has a long straddle anticipates volatility. Now observe the arrows within the loop on the short straddle, to find that they are coming together. This reminds us that the short straddle investor expects little or no movement.

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 number four.

In a straddle, investors are either buying two contracts or selling two contracts. To find the breakeven, add the two premiums, 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.

Series 7 Straddle Example

Let’s look at an example. An investor buys 1 XYZ November 50 call @ 4 and is long 1 XYZ 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 so:

Instead of clearly asking for the two breakeven points, the question may ask, “Between what two prices will the investor show 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. The arrows in the chart 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 was exactly the same as the strike price (at the money) because 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, in order 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, the investor has bought (or sold) a call and a put on the same stock, but the expiration dates 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.

Series 7 Spreads

Spread strategies are among the most difficult Series 7 topics. Thankfully, combining the aforementioned tools with some acronyms can help simplify questions spreads. Let’s use the four-step process to solve the following problem:

Write 1 ABC January 60 call @ 2

Long 1 ABC January 50 call @ 8

1. Identify the Strategy

A spread occurs when an investor longs and shorts 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 referred to as a price or vertical spread. If only the expirations are different, it is referred to as a calendar spread (also known as a “time” or “horizontal” spread). If both the strike price and expirations are different, it is known as a diagonal spread. 

2. Identify the Position

In spread strategies, the investor is either a buyer or a seller. When you determine the position, consult the block in the matrix illustrating that position, and focus on that block alone.

It is essential to address the idea of debit versus credit. If the investor has paid out more than he has received, it is a debit (DR) spread. If the investor has received more in premiums than he paid out, it is a credit (CR) spread.

There is one additional spread called the “debit call spread,” sometimes referred to as a “net debit spread”, which occurs when an investor buys an option with a higher premium and simultaneously sells an option with a lower premium. This individual deemed a “net buyer”, anticipates that the premiums of the two options (the options spread) will widen.

3. Check the Matrix

If you study the matrix above, the two positions are inside the horizontal loop illustrate spread.

4. Follow the Dollars