How to Determine the Break-Even Point for Spreads on the Series 7 Exam - dummies

How to Determine the Break-Even Point for Spreads on the Series 7 Exam

By Steven M. Rice

The Series 7 will have questions that ask you to calculate the break-even point for spreads. The thought process is different for puts and calls, but either way, you begin by finding the difference between the two premiums because you had one buy and one sell:

For call spreads, you have to add the adjusted premium (after you’ve subtracted the smaller premium from the larger one) to the lower strike price. For put spreads, you subtract the adjusted premium from the higher strike price.

The following question tests your ability to determine the break-even point on spreads.

Miguel Hammer purchased 1 Apr 40 call at 9 and shorted 1 Apr 50 call at 3. What is Miguel’s break-even point?

(A)    43

(B)    46

(C)    49

(D)    53

The right answer is Choice (B). First, focus on the buy and the sell. If the investor is buying one option and selling another, you should be able to recognize it as a spread. Therefore, you have to find the difference between the two premiums:

Next, because it’s a call spread, you have to add the adjusted premium (after subtracting the smaller from the larger) to the call strike (exercise) price to get the break-even point:

Break-even point(call spread) = 40 + 6 = 46

The following question tests your ability to answer a spread story question.

Mrs. Peabody purchased 1 DEF Mar 60 put at 5 and wrote 1 DEF Mar 65 put at 9 when DEF was trading at 68. Six months later, with DEF trading at 61, Mrs. Peabody’s DEF Mar 65 put was exercised. Mrs. Peabody held the shares of DEF for another two months before selling in the market for $62 per share. Mrs. Peabody’s Mar 60 put expired without going in-the-money.

What is Mrs. Peabody’s gain or loss?

(A)    $100 loss

(B)    $100 gain

(C)    $700 loss

(D)    $700 gain

The answer you’re looking for is Choice (B). If you got this right, you’re a master of spreads.

Begin by placing the transactions in the correct side of the options chart. Because Mrs. Peabody purchased the DEF Mar 60 put at 5, you have to enter $500 (5 × 100 shares per option) on the Money Out side of the options chart because she spent that much to purchase the option.

After that, she sold a DEF Mar 65 put for 9 and received $900 (9 × 100 shares per option) Money In for selling that option. The fact that DEF was trading at 61 when the option was exercised means nothing in this question, so feel free to ignore it.

Next, you have to exercise the 65 put that Mrs. Peabody sold. Because puts switch, you enter the strike price (multiplied by 100 shares) in the opposite side of the options chart from its premium. After you place the $6,500 in the Money Out section of the options chart, you have to sell the stock that Mrs. Peabody purchased when her option was exercised.

She sold the stock in the market for $6,200 ($62 market price × 100 shares) and received cash for that transaction, so enter $6,200 in the Money In section of the chart. Total up the two sides, and you can see that good old Mrs. Peabody has a gain of $100.

Just like other option story questions (with several things happening), enter only items in the options chart when you see action words. Remember, every time you see an action word, such as purchased, wrote, exercised, sold, and so on, you know that you have to enter something in the options chart.