Option Basics — Review for the Series 7 Exam - dummies

Option Basics — Review for the Series 7 Exam

By Steven M. Rice

Options are also known as derivatives because they derive their value from the value of an underlying security. Options give the holder the right to buy or sell the underlying security at a fixed price for a fixed period of time.

Options are one of the more heavily tested areas on the Series 7 exam.

  1. Mr. Drudge writes a naked put option on WIM common stock. What is the maximum loss per share that Mr. Drudge can incur?

    A. strike price minus the premium

    B. strike price plus the premium

    C. the entire premium received

    D. unlimited

    Answer: A. strike price minus the premium

    When writing (selling) a naked (uncovered) call option, the maximum loss is unlimited. However, when writing a naked put option, the maximum loss is the strike (exercise) price minus the premium. Put options go in the money when the price of the stock drops below the strike price.

    This means that a put option can go only so far in the money because the price of the underlying stock can drop only to zero. Therefore, the maximum loss per share is the strike price less whatever Mr. Drudge received per share when he sold the option.

  2. Which option is out of the money if ABC is at $40?

    A. ABC May 45 put

    B. ABC May 35 call

    C. ABC May 50 call

    D. ABC May 55 put

    Answer: C. ABC May 50 call

    The phrase call up and put down will help you remember that call options go in the money when the price of the stock goes above the strike price, and put options go in the money when the price of the stock goes below the strike price.

    Choice (A) is in the money because the price of the stock is below the put price of 45. Choice (B) is in the money because the price of the stock is above the 35 call strike price. Choice (D) is in the money because the price of the stock is below the 55 put strike price.

    However, Choice (C) is out of the money because the price of the stock is below the 50 call strike price.

  3. A QRS Dec 50 call is trading for 9 when QRS is at $55. What is the time value of this option?

    A. 0

    B. 4

    C. 5

    D. 9

    Answer: 4

    To determine the time value of an option, you can use the following equation: P = I + T

    where P is the premium of the option, I is the intrinsic value of the option (how much it’s in the money), and T is the time value of the option. In this case, you’re looking for the time value, so plug in the numbers for the premium and intrinsic value and then solve for time.

    The premium is 9, and the intrinsic value is 5 because call options go in the money when the stock price goes above the strike price. To determine the intrinsic value, just subtract the 50 strike price from the market price of $55, which equals 5.

    9 = 5 + T

    T = 9 – 5

    T = 4