How to Read an Option on the Series 7 Exam - dummies

How to Read an Option on the Series 7 Exam

By Steven M. Rice

Options are just another investment vehicle that (hopefully) more-savvy investors can use. To answer Series 7 questions relating to options, you first have to be able to read an option.

An owner of an option has the right, but not the obligation, to buy or sell an underlying security at a fixed price; as derivatives, options draw their value from that underlying security. Investors may either exercise the option or trade the option in the market.

The following example shows you how an option may appear on the Series 7:

Buy 1 XYZ Apr 60 call at 5

Here are the seven elements of the option order ticket and how they apply to the example:

  1. Whether the investor is buying or selling the option: Buy

    When an investor buys (or longs, holds, or owns) an option, she is in a position of power; that investor controls the option and decides whether and when to exercise the option. If an investor is selling (shorting or writing) an option, she is obligated to live up to the terms of the contract and must either purchase or sell the underlying stock if the holder exercises the option.

  2. The contract size: 1

    You can assume that one option contract is for 100 shares of the underlying stock. Although this idea isn’t as heavily tested on the Series 7 exam, an investor may buy or sell multiple options (for example, five) if she’s interested in having a position in more shares of stock. If an investor owns five option contracts, she’s interested in 500 shares of stock.

  3. The name of the stock: XYZ

    In this case, XYZ is the underlying stock that the investor has a right to purchase at a fixed price.

  4. The expiration month for the options: Apr

    All options are owned for a fixed period of time. The initial expiration for most options is 9 months from the issue date. In the preceding example, the option will expire in April. Options expire at 11:59 p.m. EST on the Saturday following the third Friday of the expiration month. Remembering the EST is generally easier than recalling the CST because 11:59 p.m. EST is right before midnight.

    Don’t confuse the option’s expiration date with the third Saturday of the expiration month; if the expiration month starts on a Saturday, the option expires on the fourth Saturday.

  5. The strike (exercise) price of the option: 60

    When the holder exercises the option, she uses the option contract to make the seller of the option buy or sell the underlying stock at the strike price. In this case, if the holder were to exercise the option, the holder of the option would be able to purchase 100 shares of XYZ at $60 per share.

  6. The type of option: call

    An investor can buy or sell a call option or buy or sell a put option. Calls give holders the right to buy the underlying security at a set price; puts give holders the right to sell. So in the example scenario, the holder has the right to buy the underlying security at the price stated in the preceding step.

  7. The premium: 5

    Of course, an option investor doesn’t get to have the option for nothing. An investor buys the option at the premium. In this case, the premium is 5, so a purchaser would have to pay $500 (5 × 100 shares per option).