Options are a decent size portions of the Series 7 exam. They come in various combinations and set ups on the Series 7. These include Options alone, spreads (buying and selling one type), straddles (using call and puts) and Stock Positions with Options.
This article focuses on Stock with Put Options Together and how to quickly figure out gains, losses and break even points for the series 7 exam. You will ACE Options if you look at with common sense. Not with memorization graphs.
What you have to remember is whenever you see options with a stock position, whether that stock position is Long Or Short – the option is used for only 1 of 2 things. Protection or Income. It is never the main focus of the strategy. So, when you are looking at the strategy and trying see where the maximum gains and maximum losses could come from, think of where your money is tied up.
If you owned 100 shares of TRW Stock at $86, you have $8600 invested. Now, if on the Series 7 exam you see a position like this and a Buy 1 TRW 80 Put for $300 with it, it’s important to see what is going on. When you own stock, you want it to go up. A put option is the right to sell the stock at the strike price (80). If the put was purchased alone, without a long stock position on the same stock, then you would want the stock to go down. Your maximum gain is based on the stock decreasing. HOWEVER, if it is owned with a long stock position, the Put is their only for protection.
In the Example:
Buy 100 Shares TRW at $86 and Buys 1 TRW 80 Put for $300
FOCUS ON THE STOCK when looking at gains, losses and Breakeven.
The put does not get in the way of your stock gain. Focus on the stock means you always want stock you have bought to go up. The option, whether it is a call or put is there for income or protection. In this case the Put was bought, so obviously this is not for income. It is for protection of the stock going down.
For this reason The maximum gain is always unlimited when you own stock and own a put. A premium was paid, so that will come off the gain, but the gain is still UNLIMITED. The stock could go to $100, $200…
Maximum Loss – The put is there to protect the stock – that is IT. Best case scenario is the stock goes through the roof and the put expires, but without the put, the stock could fall to 0. The put allows the stock to be sold at 80, regardless of how low the stock goes. It works as a stop-loss order. Only, the option is not “triggered” automatically like a stop order. The Investor must exercise the option and the put option as a cost. In this case $300. So, The maximum loss for this stock and put position is the point loss difference in the stock at 86 and the guaranteed sell price of 80, which is $600 plus the $300 premium paid. Answer: $900.
Break even point with stock and options is VERY simple for the Series 7 exam. It is total cost spent. Stock position and premium paid or received. Stock cost was 86 – premium was 3, so BREAKEVEN IS 89 You start making money at 90. Watch for that trick question. The break even and profit point are NOT THE SAME.