Tips for Series 7 Options Questions

The Series 7 exam, also known as the General Securities Representative Exam (GSRE), is a test all stockbrokers must pass, in order to acquire a license to trade securities. Although this exam covers a broad array of financial topics, questions about options tend to be the most challenging.

This article breaks down the world of options contracts and the investment strategies associated with them, while providing useful tips to help test-takers achieve passing scores.

• By definition, a contract requires two parties. When one party gains a dollar on a contract, an associated counterparty loses precisely that same amount.
• The answer to questions regarding spreads, are almost always either “Wide” or “Narrow”, therefore “Stay the same” and “Invert” may be immediately eliminated from consideration. 

Of the 50 or-so options related questions on the Series 7 exam, approximately 35 deal specifically with options strategies. (For related reading, see: 10 Options Strategies to Know.)

Options strategies questions in the Series 7 exam, cover the following areas: 

• Puts
• Calls
• Straddles
• Spreads
• Hedges
• Covered contracts

Within these sub-categories, questions focus on the following primary areas:

• Maximum gain
• Maximum loss
• Breakeven
• Expected direction of stock movement for profit (up/down, bullish/bearish)

By definition, a contract requires two parties. When one party gains a dollar on a contract, a connected counterparty loses precisely that same amount. This transaction is referred to as a zero-sum game, where the buyer and seller reach the breakeven point simultaneously. 

The majority of options investors aren't interested in buying or selling stocks. Rather, they are typically more intent of profiting from trading the contracts themselves. In that sense, the options exchanges are much like horse racing tracks. While some people visit the track to buy or sell a horse, most are there to bet on the races.

There are many synonymous terms in the options space. As the following Options Matrix chart (Figure 1) demonstrates, the term "buy" is interchangeable with "long" or "hold”, while the term "sell" can be replaced with "short" or "write." The Series 7 exam notoriously interchanges these terms, often within the same question, therefore it behooves test-takers to recreate this matrix on a piece of scratch paper before starting the exam. 

Figure 1

As Figure 1 demonstrates, buyers pay premiums to secure all the rights, while sellers receive premiums for shouldering the obligations (also known as risk). To this end, an options contract is similar to a car insurance contract, where a buyer pays the premium and has the right to exercise the contract, where he cannot lose any more than the premium paid. Meanwhile, the seller has the obligation to perform, if called upon by the buyer, where the most he can gain is the premium received. These same principals apply to options contracts.

Because an option has a definite expiration date, the time value of the contract is often called a “wasting asset”. Keep in mind that buyers naturally want the contract to be exercisable, even if they’re unlikely to exercise, since they’re traditionally more apt to sell the contract for a profit. On the other hand, sellers want the contract to expire worthless, because this lets them retain their entire premium, thus maximizing gains.

Series 7 test-takers are often unsure how to approach options questions, however the following four-step process offers some clarity:

1. Identify the strategy.
2. Identify the position.
3. Use the matrix to verify desired movement.
4. Follow the dollars.

Series 7 test-takers should pair these tips with the following formula for the options premium:

Premium = Intrinsic Value + Time Value

Consider the following 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 trades at 47. The investor closes the contract. What is the gain or loss to the investor?

Using the four-step process, a test taker may establish the following points:

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:

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's important to note that buyers want the contracts to be in the money (have an 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’s 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.

Figure 2

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

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

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.

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.

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.

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, 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.

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:

Figure 3

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

If, in the identification process, the investor has bought (or sold) a call and a put on the same stock, but the expiration dates 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.

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

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. 

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.

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

Tip 1: It may be helpful to write the $Out/$In cross directly below the matrix so the vertical bar is exactly below the vertical line that divides the buy and sell. That way, the buying side of the matrix will be directly above the DR side and the selling side of the matrix will be exactly above the CR side.

Tip 2: 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, the maximum loss for the seller and the breakeven for both will always be between the strike prices.

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, remember the acronym 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.

Write 1 ABC January 60 call @ 2

Long 1 ABC January 50 call @ 8

• Maximum gain = 4
• Breakeven point = 56
• Movement of ABC stock = +6
• Difference in strike prices = 10

When the stock has risen by six points to the breakeven point, the investor may only gain four points of profit ($400). Notice that 6 + 4 = 10, the number of points between the strike prices.

Above 60, the investor has no gain or loss. 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 sure to remember the rights and obligations, when solving spread problems, such as the following question:

Write 1 ABC January 60 call @ 2

Long 1 ABC January 50 call @ 8

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

1. Narrow
2. Widen
3. Stay the same
4. Invert

This question may be somewhat simplified by the fact that the answer to questions regarding spreads, are almost always either “Wide” or “Narrow”, therefore “Stay the same” and “Invert” may be eliminated from consideration.

Secondly, remember 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. Buyers want to be able to exercise.

If the investor has created a credit spread, use the acronym CVN, which stands for Credit/Valueless/Narrow. Sellers (those in credit positions), want the contracts to expire valueless and the spread in premiums to narrow.

Debit (Bear) Put Spread:

• 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 premium
• Breakeven = higher strike price – net premium

For breakevens, bear in mind the helpful acronym PSH: In a Put spread, Subtract the net premium from the Higher strike price.

Although options contracts questions in the Series 7 exam are numerous, their scope is limited. The four-step process detailed can be helpful in achieving passing scores. Practicing as many options questions as possible can dramatically increase the chances of exam success.

(For everything you need to know for the Series 7 exam, see: Free Series 7 Online Study Guide.)