How to Capture Options Questions in the Series 7 Exam
The Series 7 exam, also known as the General Securities Representative Exam (GSRE), is a prove all stockbrokers must pass, in order to acquire a license to trade securities. Although this exam covers a ample array of financial topics, questions about options tend to be the most challenging.
This article breaks down the creation of options contracts and the investment strategies associated with them, while providing useful tips to help test-takers carry out passing scores.
Fast Facts:
- By definition, a contract requires two parties. When one party gains a dollar on a pucker, an associated counterparty loses precisely that same amount.
- The answer to questions regarding spreads, are almost till the end of time either “Wide” or “Narrow”, therefore “Stay the same” and “Invert” may be immediately eliminated from consideration.
Options Confusions
Of the 50 or-so options related questions on the Series 7 exam, approximately 35 deal specifically with alternatives strategies. (For related reading, see: 10 Options Strategies to Know.)
Options strategies questions in the Series 7 exam, cover the occupy oneself with areas:
Within these sub-categories, questions focus on the following primary areas:
- Maximum gain
- Maximum forfeiture
- Breakeven
- Expected direction of stock movement for profit (up/down, bullish/bearish)
The Basics
It Takes Two to Make a Compact
By definition, a contract requires two parties. When one party gains a dollar on a contract, a connected counterparty loses meticulously that same amount. This transaction is referred to as a zero-sum game, where the buyer and seller reach the breakeven direct simultaneously.
Most Options Contracts Are Not Exercised
The majority of options investors aren’t interested in buying or selling stocks. Choose, they are typically more intent of profiting from trading the contracts themselves. In that sense, the options swops 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 dog-races.
Terminology Tangles
There are many synonymous terms in the options space. As the following Options Matrix chart (Number 1) demonstrates, the term “buy” is interchangeable with “long” or “hold”, while the term “sell” can be replaced with “concise” 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 report of scratch paper before starting the exam.
Buyers’ Rights, Sellers’ Obligations
As Figure 1 demonstrates, buyers pay premiums to shut all the rights, while sellers receive premiums for shouldering the obligations (also known as risk). To this end, an options diminish is similar to a car insurance contract, where a buyer pays the premium and has the right to exercise the contract, where he cannot give up 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 get is the premium received. These same principals apply to options contracts.
Time Value for Buyers and Sellers
Because an election has a definite expiration date, the time value of the contract is often called a “wasting asset”. Keep in mind that customers naturally want the contract to be exercisable, even if they’re unlikely to exercise, since they’re traditionally more apt to trade the contract for a profit. On the other hand, sellers want the contract to expire worthless, because this lets them employ their entire premium, thus maximizing gains.
Four No-Fail Steps to Follow
Series 7 test-takers are habitually unsure how to approach options questions, however the following four-step process offers some clarity:
- Identify the design.
- Identify the position.
- Use the matrix to verify desired movement.
- Follow the dollars.
Series 7 test-takers should pair these surmount upsets with the following formula for the options premium:
Premium = Intrinsic Value + Time Value
Consider the following inquiry: An investor is long 1 XYZ December 40 call at 3. Just prior to the close of the market on the final trading day ahead expiration, XYZ stock trades at 47. The investor closes the contract. What is the gain or loss to the investor?
Using the four-step development, a test taker may establish the following points:
- Identify the strategy – a call contract
- Identify the position – long = buy = repress (has the right to exercise)
- Use the matrix to verify desired movement – bullish, wants the market to rise
- Follow the dollars – Make a index of dollars in out:
| $ Out | $ In |
| – | – |
| – | – |
| – | – |
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 intentional value of a company, using fundamental analysis. The intrinsic value, which may or may not be the same as the current market value, make clears 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 proper value), while sellers want contracts to be out of the money (have no intrinsic value).
In the problem, because the investor is elongated the contract, they have paid a premium. The problem likewise states that the investor closes the position. An opportunities investor who buys to close the position will sell the contract, offsetting the open long position. This investor pass on then sell the contract for its intrinsic value, because there’s no time value remaining. And because the investor swallow for three ($300) and sells for the intrinsic value of seven ($700), he would lock in a $400 profit.
By examining Depend on 2, entitled “Intrinsic Value”, it’s clear that the contract is a call and that the market is above the strike (employ) price, and that the contract is in the money, where it has an intrinsic value. Conversely, the put contracts operate in the opposite direction.
Ways for Calls
Long Calls:
- Maximum gain = unlimited
- Maximum loss = premium paid
- Breakeven = strike payment + premium
Short Calls:
- Maximum gain = premium received
- Maximum loss = unlimited
- Breakeven = strike bonus + premium
Formulas for Puts
Long Puts:
- Maximum gain = strike price – premium x 100
- Maximum loss = thin on the ground b costly paid
- Breakeven = strike price – premium
Short Puts:
- Maximum gain = premium received
- Maximum depletion = strike price – premium x 100
- Breakeven = strike price – premium
In Figure 1, the buyers of puts are bearish. The
Straddle Designs and Breakeven Points
Questions regarding straddles on the Series 7 tend to be limited in scope, primarily focusing on straddle policies 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 single out 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 verbatim at the same time stock with the same expiration and the same strike, the strategy is a straddle.
Consult Figure 1. If you look at gaining a call and buying a put, an imaginary loop around those positions is a straddle—in fact, it is a
Step 3 and 4
By looking at the long or sweet deficient in 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, pass over 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 unqualified 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 become infected with side. A straddle always has two breakevens.
Straddle Example
Let’s look at an example. An investor buys 1 XYZ November 50 gather @ 4 and is long 1 XYZ November 50 put @ 3. At what points will the investor break even?
Hint: now you’ve identified a straddle, write the two contracts out on your scratch paper with the call contract above the put contract. This earns the process easier to visualize, like so:
Instead of clearly asking for the two breakeven points, the question may ask, “Between what two assesses will the investor show a loss?” If you’re dealing with a long straddle, the investor must hit the breakeven point to redeem the premium. Movement above or below the breakeven point will be profit. The arrows in the chart above match the arrows within the twist for a long straddle. The investor in a long straddle is expecting volatility.
Note: Because the investor in a long straddle anticipates volatility, the maximum loss would occur if the stock price was exactly the same as the strike price (at the money), because neither understanding would have any intrinsic value. Of course, the investor with a short straddle would like the market guerdon to close
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 closing 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 games—volatility or no movement—apply.
Spreads
Spread strategies are among the most difficult Series 7 topics. Thankfully, combining the aforementioned media with some acronyms can help simplify questions spreads. Let’s use the four-step process to solve the following problem:
Put down 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 unchanging type of options contracts (calls or puts) with differing expirations, strike prices or both. If only the pull prices are different, it is referred to as a price or
2. Identify the Position
In spread strategies, the investor is either a buyer or a seller. When you choose the position, consult the block in the matrix illustrating that position, and focus on that block alone.
It is essential to hail the idea of debit versus credit. If the investor has paid out more than he has received, it is a
3. Check the Matrix
If you study matrix on the top of, the two positions are inside the horizontal loop illustrate spread.
4. Follow the Dollars
| (DR) | (CR) |
| $800 | $200 |
| $600 |
Tip 1: It may be helpful to write the $Out/$In cross just 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 wish 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 important strike price is written above the lower strike price. Once you’ve identified a spread, write the two contracts on your damage paper with the higher strike price above the lower strike price. This makes it much easier to visualize the increase 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 intention always be between the strike prices.
Formulas and Acronyms for Spreads
Debit (Bull) Call Spreads:
- Maximum forfeiture = (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 reservoir must rise to at least 56 for this investor to recover the premium paid.
Write 1 ABC January 60 evoke @ 2
Long 1 ABC January 50 call @ 8
- Maximum gain = 4
- Breakeven point = 56
- Movement of ABC stock = +6
- Difference in strike premiums = 10
When the stock has risen by six points to the breakeven point, the investor may only gain four points of profit ($400). Announcement that 6 + 4 = 10, the number of points between the strike prices.
Above 60, the investor has no gain or loss. When an investor over persuades or writes an option, they are obligated. This investor has the right to purchase at 50 and the obligation to deliver at 60. Be undeviating to remember the rights and obligations, when solving spread problems, such as the following question:
Write 1 ABC January 60 draft b call @ 2
Long 1 ABC January 50 call @ 8
To profit from this position, the spread in premiums must:
- Narrow
- Add to
- Stay the same
- Invert
This question may be somewhat simplified by the fact that the answer to questions regarding spreads, are nearly always either “Wide” or “Narrow”, therefore “Stay the same” and “Invert” may be eliminated from consideration.
Secondly, tip 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 character 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 tribute positions), want the contracts to expire valueless and the spread in premiums to narrow.
Formulas for Put Spreads
Debit (Bear) Put Spread:
- Utmost gain = difference in strike prices – net premium
- Maximum loss = net premium
- Breakeven = higher strike price – net scant
Credit (Bull) Put Spread:
- Maximum gain = net premium
- Maximum loss = difference in strike prices – net premium
- Breakeven = considerable strike price – net premium
For breakevens, bear in mind the helpful acronym PSH: In a Put spread, Subtract the net premium from the Higher punch price.
The Bottom Line
Although options contracts questions in the Series 7 exam are numerous, their scope is minimal. The four-step process detailed can be helpful in achieving passing scores. Practicing as many options questions as possible can dramatically better the chances of exam success.