How to Calculate Profit or Loss for Investor Trading Options on the Series 7 Exam
On the Series 7, not only do you need to know the difference between opening and closing transactions, but you also have to be able to calculate the profit or loss for an investor trading options. This process is actually pretty easy when you break it down.
Open or close the transaction
When distinguishing between opening and closing transactions, your key is to know whether this transaction is the first time or the second time the investor is buying or selling an option: The first time is an opening, and the second time is a closing.
Here are your opening transactions:
Opening purchase: An opening purchase occurs when an investor first buys a call or a put.
Opening sale: An opening sale is when an investor first sells a call or a put.
If an investor already has an option position, the investor has to close that position by doing the opposite — through a closing transaction. If the investor originally purchased the option, she has to sell to close it. By contrast, if she originally sold the option, she has to purchase to close. Here are the two types of closing transactions:
Closing purchase: A closing purchase occurs when an investor buys herself out of a previous option position that she sold. For example, if an investor sold an XYZ Oct 40 call (opening sale), she would have to buy an XYZ Oct 40 call to close out the position. The second transaction is a closing purchase.
Closing sale: A closing sale occurs when an investor sells herself out of a previous option position that she purchased. For example, if an investor bought an ABC Sep 60 put (opening purchase), she would have to sell an ABC Sep 60 put to close out the position. The second transaction is a closing sale.
When determining opening or closing transactions, whether the transactions are both calls or both puts doesn’t matter.
The following question tests your knowledge of opening and closing transactions.
Mr. Dimpledell previously bought 1 XYZ Oct 65 call at 8 when the market price of XYZ was 64. XYZ is currently trading at 69, and Mr. Dimpledell decides that now would be a good time to sell the option that he previously purchased. The second option order ticket would be marked
(A) opening sale
(B) opening purchase
(C) closing sale
(D) closing purchase
The right answer is Choice (C). This is the second time that Mr. Dimpledell does something with the option that he owns; therefore, the move has to be a closing transaction, and you can immediately eliminate Choices (A) and (B). Mr. Dimpledell has to sell himself out of the position because he owns the option. The second order ticket would have to be marked closing sale.
How to calculate gains and losses
In addition to knowing how to mark the order ticket, you have to be able to figure out an investor’s gain or loss when trading options. This task isn’t difficult after you master the options chart. The key thing to remember is that when an investor closes, she does the opposite of what she did before.
The following question tests your mastery of options trades.
Mrs. Cleveland purchased 100 shares of DPY stock at $50 per share. Two weeks later, Mrs. Cleveland sold 1 DPY Oct 55 call at 6. Mrs. Cleveland held that position for three months before selling the DPY stock at $52 per share and closing the DPY Oct 55 call at 4. What is Mrs. Cleveland’s gain or loss on the transactions?
(A) $400 gain
(B) $400 loss
(C) $600 gain
(D) no gain or loss
The correct answer is Choice (A). This question introduces stock trades as well as options transactions, but that’s no problem. The options chart works for questions involving actual stocks and options or just options.
When you approach the transactions one at a time, the problem-solving process is actually pretty straightforward. Mrs. Cleveland purchased 100 shares of DPY stock at $50 per share for a total of $5,000; therefore, you enter $5,000 in the Money Out side of the options chart.
Next, she sold the DPY 55 call for a premium of 6, so you need to enter $600 (6 × 100 shares per option) on the Money In side of the chart because she received money for selling that option.
Three months later, Mrs. Cleveland sold the stock for $5,200 ($52 per share × 100 shares) and received money for selling the stock. Place the $5,200 in the Money In side of the options chart. When closing the option, the customer has to do the opposite of what she did before.
Originally, Mrs. Cleveland sold the option, so to close, she has to buy the option. She purchased the option for $400 (4 × 100 shares per option), so enter $400 in the Money Out side of the options chart. All that’s left for you to do is total up the two sides. Mrs. Cleveland has $5,800 in and $5,400 out for a gain of $400.