Option contracts offer investors security and the Series 7 will expect you to be able to determine the maximum gain and loss for these. When an investor purchases or sells option contracts on securities she owns, that investor is choosing an excellent way to protect against loss or to bring additional funds into her account. The most common form is when an investor sells covered call options.
If an investor is selling a call option against a security that she owns, the investor is considered to be covered. She’s covered because if the option is exercised, the investor has the stock to deliver.
Take the following position as an example:
Buy 100 shares of QRS at $47 per share
Sell 1 QRS Dec 55 call at 4
Find this investor’s maximum potential loss.
Place the purchases and sales in the options chart. This investor purchased 100 shares of QRS stock at $47 per share for a total of $4,700. That’s money spent, so enter $4,700 in the Money Out side of the options chart.
Next, this investor sold 1 QRS Dec 55 call for a total premium of $400 (4 × 100 shares per option) and received money for selling that option, so you enter $400 in the Money In section of the options chart.
This investor has more Money Out than Money In, so the investor’s maximum potential loss is $4,300 ($4,700 minus $400).
Determine the investor’s maximum potential gain.
Placing the two transactions (in this case the stock purchase and the option sale) in the options chart helps you calculate the maximum gain as well as the maximum loss. To find the maximum gain, you need to exercise the option.
You always exercise at the strike price, which in this case is 55. Take the $5,500 (55 × 100 shares per option) and place it under its premium. Total the two sides and you find that the Money In is $1,200 more than the Money Out, so that’s the investor’s maximum potential gain.
When the investor is covered, finding the break-even point is nice and easy for stock and options. Although you can use the options chart, you really don’t need to in this example case. First, look at how much the investor paid for the stock; then look at how much more she paid or received for the option. Find the difference, and you have your break-even point:
Because this investor paid $47 per share for the stock and received back $4 per share for selling the option, this investor would need to receive another $43 per share to break even.
Here’s how to find the break-even point for stock and options:
If the investor purchased twice (bought the stock and bought a protective put option), add the stock price and the premium.
If the investor sold twice (sold short the stock and sold an option), add the stock price and the premium.
If the investor had one buy and one sell (for example, bought the stock and sold the option or sold short the stock and bought the option), subtract the premium from the stock price.
The following example tests your knowledge on stock and option problems.
Mr. Bullwork sold short 100 shares of DIM common stock at $25 per share and bought 1 DIM Aug 30 call at 3 to hedge his position. What is Mr. Bullwork’s maximum potential loss from this strategy?
(A) $300
(B) $800
(C) $2,200
(D) $2,700
The answer you’re looking for is Choice (B). You need to enter the initial purchase and sale into the options chart. Your friend and client, Mr. Bullwork, sold short 100 shares of DIM common stock at $25 per share for a total of $2,500. Because Mr. Bullwork received the $2,500 for selling short, you have to put $2,500 in the Money In side of the options chart.
Next, Mr. Bullwork purchased a DIM Aug 30 call to hedge (protect) his position in case the stock started increasing in value. You have to enter the $300 (3 × 100 shares per option) in the Money Out side of the options chart, because he paid money to purchase the option. Stop and take a look to see whether that calculation answers the question.
You see more Money In at this point than Money Out, so you have a maximum gain; therefore, you have to exercise the option to get the answer you need. Make sure you exercise the option at the strike price. The strike price is 30, so enter $3,000 under its premium. Total up the two sides, and you see that the maximum potential loss for Mr. Bullwork is $800.