What You Should Know About Options for the Series 7 Exam
All option strategies, when broken down, are made up of simple call and/or put options. The Series 7 exam will expect you to understand the basic differences among these options.
Call options: The right to buy
A call option gives the holder the right to buy 100 shares of a security at a fixed price and the seller the obligation to sell the stock at the fixed price. Owners of call options want the price of the stock to increase. If the price of the stock increases above the strike price, holders can either exercise the option or sell for a profit.
For example, assume that Ms. Smith buys 1 DEF October 40 call option. Ms. Smith bought the right to purchase 100 shares of DEF at 40. If the price of DEF increases to over $40 per share, this option becomes very valuable to Ms. Smith, because she can purchase the stock at $40 per share and sell it at the market price or sell the option at a higher price.
If DEF never eclipses the 40 strike price, then the option doesn’t work out for poor Ms. Smith and she doesn’t exercise the option. However, it does work out for the seller of the option, because the seller receives a premium for selling the option.
Put options: The right to sell
You can think of a put option as being the opposite of a call option. The holder of a put option has the right to sell 100 shares of a security at a fixed price, and the writer of a put option has the obligation to buy the stock if exercised.
Owners of put options want the price of the stock to decrease. However, sellers of put options would keep the option from going in-the-money and allow them to keep the premiums they received.
For example, assume that Mr. Jones buys 1 ABC October 60 put option. Mr. Jones is buying the right to sell 100 shares of ABC at 60. If the price of ABC decreases to less than $60 per share, this option becomes very valuable to Mr. Jones.
If you were in Mr. Jones’ shoes and ABC were to drop to $50 per share, you could purchase the stock in the market and exercise the option to sell the stock at $60 per share, which would make you (the new Mr. Jones) very happy.
If ABC never drops below the 60 strike price, then the option doesn’t work out for Mr. Jones and he doesn’t exercise the option. It does work out for the seller of the option, because the seller receives a premium for selling the option that she gets to keep.
Options in-, at-, or out-of-the-money
To determine whether an option is in- or out-of-the-money, you have to figure out whether the investor would be able to get at least some of their premium money back if the option were exercised.
Here’s how you know where-in-the-money an option is:
When an option is in-the-money, exercising the option lets investors sell a security for more than its current market value or purchase it for less — a pretty good deal.
The intrinsic value of an option is the amount that the option is in-the-money; if an option is out-of-the-money or at-the-money, the intrinsic value is zero.
When an option is out-of-the-money, exercising the option means investors can’t get the best prices; they’d have to buy the security for more than its market value or sell it for less. Obviously, holders of options that are out-of-the-money don’t exercise them.
When the strike price is the same as the market price, the option is at-the-money; this is true whether the option is a call or a put.
Call options go in-the-money when the price of the stock is above the strike price. Suppose, for instance, that an investor buys a DEF 60 call option and that DEF is trading at 62. In this case, the option would be in-the-money by two points. If that same investor bought that DEF 60 call option when DEF was trading at 55, the option would be out-of-the-money by five points.
A put option goes in-the-money when the price of the stock drops below the strike price. For example, a TUV 80 call option is in-the-money when the price of TUV drops below 80. The reverse holds also: If a put option is in-the-money when the price of the stock is below the strike price, it must be out-of-the-money when the price of the stock is above the strike price.
The following question tests your knowledge of options being in- or out-of-the-money.
Which TWO of the following options are in-the-money if ABC is trading at 62 and DEF is trading at 44?
I. An ABC Oct 60 call option
II. An ABC Oct 70 call option
III. A DEF May 40 put option
IV. A DEF May 50 put option
(A) I and III
(B) I and IV
(C) II and III
(D) II and IV
The correct answer is Choice (B). Start with the strike prices.
You’re calling up or putting down from the strike prices, not from the market prices. Because call options go in-the-money when the market price is above the strike price, Statement I is the only one that works for ABC. An ABC 60 call option would be in-the-money when the price of ABC is above 60. ABC is currently trading at 62, so that 60 call option is in-the-money.
For the ABC 70 call option to be in-the-money, ABC would have to be trading higher than 70. Next, use put down for the DEF put options, because put options go in-the-money when the price of the stock goes below the strike price. Therefore, Statement IV makes sense because DEF is trading at 44, and that’s below the DEF 50 put strike price but not the 40 put strike price.