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. 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. 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. 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: 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 of exercising contracts. Write the matrix down on your scratch paper before starting the exam and refer to it frequently to help keep you on track.
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 seller has the obligation to perform when and if called upon by the buyer; the most the seller can gain is the premium received.
Apply these ideas to options contracts. Question "Call Up and Put Down" Many people have been misled by the old saying "call up and put down. 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.
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.
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. 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:. 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. 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 The investor closes the contract. What is the gain or loss to the investor?
Questions in the exam may refer to a situation in which a contract is "trading on its 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. How can you arrive at the intrinsic value so easily?
Look at Figure 2, the intrinsic value chart. Put contracts operate in exactly the opposite direction. 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. 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: 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 If the breakeven point is 37, multiply by to get the maximum possible gain for the buyer: Questions regarding straddles on the Series 7 tend to be limited in scope.
Primarily they focus on straddle strategies and the fact that there are always two breakeven points. Steps 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 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 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. Let's look at an example. At what points will the investor break even? This makes the process easier to visualize. Instead of clearly asking for the two breakeven points, the question may ask: 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.
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. Spread 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. 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. 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 debit versus 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.More...