Series 7 Questions About Options
The Series 7 exam, also known as the General Securities Representative Exam (GSRE), is a test that all stockbrokers must pass in order to acquire a license to sell 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. It provides useful tips to help those taking the exam to achieve passing scores.
Key Takeaways
- The steps detailed in this article can help those taking the Series 7 exam to achieve passing scores.
- Although options contracts questions in the Series 7 exam are numerous, their scope is limited.
- Learn as much as you can about options as a product and the way investors use them so that you’ll feel comfortable when those questions appear on the test.
- Practice answering as many options questions as possible to increase the chances of exam success.
Question Areas
Of the 50 or so options-related questions on the Series 7 exam, approximately 35 deal specifically with options strategies.
These options strategies questions cover the following areas:
Within the above categories, questions focus on these primary areas:
- Maximum profit or gain
- Maximum loss
- Breakeven
- Expected direction of stock movement for profit—including up or down, bullish or bearish
The Options Basics
By definition, an option contract requires two parties. When one party gains a dollar on a contract, the counterparty loses precisely that 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 on profiting from trading the option contracts themselves.
In that sense, the options exchanges are much like horse racing tracks, where people bet on the outcome of races and don’t want to take home the horses. Most people buying and selling options are betting on trade outcomes and don’t want the underlying stocks.
Terminology Tangles
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 uses these terms interchangeably, often within the same question. Therefore it behooves test takers to become familiar with this matrix before taking the exam.
Options Rights and Obligations
Option contract buyers pay premiums to secure all the rights, while sellers receive premiums for shouldering the obligations—also known as risk.
With this in mind, an options contract is similar to a car insurance contract, where a buyer pays the premium and has the right to exercise the contract. He cannot lose any more than the premium paid.
Meanwhile, the seller has the obligation to perform, if called upon by the buyer, and the most he can gain is the premium already received. These same principals apply to options contracts.
Time Value for Buyers and Sellers
Because an option has a specific expiration date, the time value of the option contract is often deemed synonymous with a wasting asset.
Buyers naturally want the contract to be exercisable, even if they’re unlikely to exercise it, since they’re more interested in selling 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.
Steps That Clarify Questions About Options
Some Series 7 test takers are unsure of how to approach options questions. The following four-step process can offer some clarity:
- Identify the strategy.
- Identify the position.
- Use the matrix to verify the desired movement.
- Follow the dollars.
Series 7 test takers should pair these four steps with the following formula for the options premium:
Premium = Intrinsic Value + Time Value
Consider this Problem
An investor is long 1 XYZ December 40 call at 3. Just before 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:
- Identify the strategy: a bullish investor purchases a call contract
- Identify the position: long = buy = hold (buyer has the right to exercise)
- Use the matrix to verify desired movement: buyer wants the market to rise
- Follow the dollars: make a list of dollars in and out
| $ Out | $ In |
| – | – |
| – | – |
| – | – |
The Answer
In the problem above, the investor paid a premium to buy the contract and later closed the position. They sell it for its intrinsic value because there is no time value remaining. And because the investor bought at three ($300) and sold for the intrinsic value of seven ($700), they locked in a $400 profit.
Intrinsic Value
Questions in the exam may refer to a situation in which a contract is trading on its intrinsic value, which is the value of a company calculated 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).
Figure 2, entitled “Intrinsic Value,” demonstrates that a call is in the money (and has intrinsic value) when the market value of the security is above the strike (exercise) price.
A put is in the money when the market value is below the strike (exercise) price.
Keys to Profit & Loss
For Calls
Long Calls:
- The maximum gain = unlimited
- Maximum loss = premium paid
- Breakeven point = strike price + premium
Short Calls:
- The maximum gain = premium received
- Maximum loss = unlimited
- Breakeven point = strike price + premium
For Puts
Long Puts:
- The maximum gain = strike price – premium x 100
- Maximum loss = premium paid
- Breakeven point = strike price – premium
Short Puts:
- The maximum gain = premium received
- Maximum loss = strike price – premium x 100
- Breakeven point = strike price – premium
In Figure 1 above, 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 those amounts, 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
An option contract straddle involves buying or selling a call option and a put option with the same strike price and expiration date.
Questions on the Series 7 exam about straddles tend to be limited in scope. Moreover, they focus primarily on straddle strategies and the fact there are always two breakeven points.
Determine the Straddle Type
The first step when you see any multiple options strategy on the exam is to identify the type of straddle. 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 price, the strategy is a straddle. The position is a long straddle.
If you are selling a call and a put on the same stock with the same expiration and the same strike price, the position 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 indicates that the investor who has a long straddle anticipates volatility in the underlying stock.
The arrows within the loop on the short straddle are coming together. This reminds us that the short straddle investor expects little or no movement in the underlying stock.
Investors implement a straddle strategy to make money from either price volatility (with the long straddle) or price stability (with the short straddle). The key to the strategy is that they don’t have to predict one direction that the market might take. They’re covered no matter which direction the market moves.
Determine the Breakeven Points
As mentioned above, in a straddle, investors are either buying two contracts or selling two contracts, and there are always two breakeven points.
• To find the breakeven point in a long straddle (the call contract side), add the two premiums paid, then add that total to the strike price for the upper breakeven point. Subtract the sum from the strike price for the lower breakeven point.
• To find the breakeven point in a short straddle (the put contract side), add the total of the premiums received to the strike price for the upper breakeven point. Subtract the sum from the strike price for the lower breakeven point.
Straddle Example
An investor buys 1 XYZ November 50 call at 4 and is long 1 XYZ November 50 put at 3. At what prices will the investor break even?
Hint: once you’ve identified a straddle, write the two contracts out on scratch paper with the call contract above the put contract. This makes the process easier to visualize, like so:
Instead of clearly requesting the two breakeven points, the exam 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 paid. 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 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 (long a call)
- Maximum loss = both premiums
- Breakeven points = add the sum of both premiums paid to the call strike price for the upper breakeven point and subtract the sum from the put strike price for the lower breakeven point
Short Straddles:
- Maximum gain = both premiums
- Maximum loss = unlimited (short a call)
- Breakeven = add the sum of both premiums received to the call strike price for the upper breakeven point and subtract the sum from the put strike price for the lower breakeven point
Combination Straddles
If you discover that 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 apply, regardless of the degree of volatility.
Spread Strategies
An option contract spread involves buying and selling more than one option contract on the same stock but with a different strike price or expiration date (or both).
Spread strategies are among the most difficult Series 7 topics. Thankfully, the aforementioned tips and tools can help simplify exam questions about spreads.
Let’s use the same four-step process above 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 with only different strike prices is referred to as a price or vertical spread.
- A spread with only different expirations is referred to as a calendar spread (also known as a time or horizontal spread).
- A spread with different strike prices and expirations is referred to 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. This spread occurs when an investor buys an option with a higher premium and simultaneously sells an option with a lower premium. This individual is deemed a net buyer and 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 inside the horizontal loop illustrate a spread.
4. Follow the Dollars
| (DR) | (CR) |
| $800 | $200 |
| $600 |
- It may be helpful to write the $ Out/$ In chart directly below the matrix so its 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.
- 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 point for both will always be between the strike prices.
Always consider the rights and obligations of the option investor when solving spread problems in the exam.
Formulas and Acronyms for Spreads
Debit (Bull) Call Spreads:
- Maximum loss = net premium paid
- The maximum gain = difference in strike prices – net premium
- Breakeven point = lower strike price + net premium
Credit (Bear) Call Spreads:
- Maximum loss = difference in strike prices – net premium
- The maximum gain = net premium received
- Breakeven point = 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.
Back to our problem above, the 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 will lose the entire premium.
- Maximum gain = the difference in strike prices – net premium. Thus, (60-50) – 6 = 10 – 6 = 4 x 100 = $400
- Breakeven point: Since this is a call spread, we will add the net premium to the lower strike price: 6 + 50 = 56. The stock must rise at least six points to 56 for this investor to recover the premium paid.
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.
Another question you must consider with regard to a spread is, what must the spread do for the investor to profit?
Write 1 ABC January 60 call @ 2
Long 1 ABC January 50 call @ 8
To profit from this position, the spread in premiums must:
- Narrow
- Widen
- Stay the same
- Invert
The answer to such questions regarding spreads is almost always either widen or narrow. Therefore you can immediately eliminate the potential answers of “Stay the same” and “Invert.”
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 with no value and the spread in premiums to narrow.
Formulas for Put Spreads
Debit (Bear) Put Spread:
Maximum Gain=DSP – Net PremiumMaximum Loss=Net PremiumBreakeven=Higher Strike Price – Net Premium
Credit (Bull) Put Spread:
Maximum Gain=Net PremiumMaximum Loss=DSP – Net PremiumBreakeven=Higher Strike Price – Net Premiumwhere:DSP = Difference in Strike Prices
For breakevens, bear in mind the helpful acronym PSH: In a Put spread, Subtract the net premium from the Higher strike price.
What Types of Options Will I Be Asked About on the Series 7 Exam?
According to FINRA’s Securities Industry Essentials (SIE) Examination content outline, the exam covers equity options and index options.
Why Is the Options Section of the Exam So Difficult?
It’s considered difficult because of the somewhat complicated nature of options, of the various options strategies, and the math involved.
How Can I Improve Preparation for the Options Section of the Series 7 Exam?
One way to start is to take the time to understand clearly the basics of options and how options work as a financial product. Then, become as familiar as possible with the various positions that investors can take using options contracts, and, importantly, why they would take each one. Armed with this essential information and comprehension, you’ll be better able to quickly address the questions.
The Bottom Line
Many financial professionals who buy and sell securities have found the options section of the Series 7 exam difficult. Although the questions are numerous, their scope has been limited.
The information and four-step process provided above may be helpful to you in preparing for and passing the exam. Practicing as many options questions as possible can dramatically increase the chances of your success.
Read the original article on Investopedia.