Option Straddles and Combinations — Review for the Series 7 Exam - dummies

Option Straddles and Combinations — Review for the Series 7 Exam

By Steven M. Rice

Options give holders a leveraged position because they have an interest in a large amount of securities for a relatively small outlay of cash. Options are risky investments and aren’t for everyone because of the likelihood of losing all the money invested.

Practice questions

  1. One of your clients is holding DUD common stock. You and your client believe that DUD’s market price will stay at roughly the same price for the next year.

    Which of the following option positions would you recommend for the client to be able to generate some additional income on DUD?

    A. Buy a DUD combination.

    B. Write a DUD straddle.

    C. Buy a DUD call.

    D. Buy a DUD put.

    Answer: B. Write a DUD straddle.

    To generate income, your client has to sell something. The only answer choice that has your client selling something is Choice (B). Writing (selling) a straddle would allow your client to generate income on a stock that’s remaining stable because he’d receive the premiums for selling the straddle. Your client would be able to profit if neither the call option nor put option that are part of the straddle go too much in the money.

  2. An investor with no other positions shorts an XYZ Dec 35 straddle while XYZ is trading at 35. This investor is looking for XYZ to

    A. increase in value

    B. decrease in value

    C. remain stable

    D. either Choice (A) or (B)

    Answer: C. remain stable

    Selling a straddle is selling a call and selling a put on the same stock, same strike price, and same expiration month. When selling a straddle, the most you can hope to make is the premiums that you received.

    In this case, the investor would hope that the stock price of XYZ stays right at the strike price of 35 so that neither option will be exercised. If that happens, he gets to keep the premiums he received for selling the options. Remember, the buyer and the seller want opposite things to happen — the seller wants stability, and the buyer wants volatility.

  3. An investor sells a DEF at-the-money straddle. This investor is

    A. bullish on DEF

    B. bearish on DEF

    C. neutral on DEF

    D. cannot be determined

    Answer: C. neutral on DEF

    When an investor sells an at-the-money straddle, the investor has already maximized his profit. If the price of the underlying stock moves in either direction, one of the options will go in the money, and the seller will start losing money. Therefore, this investor wants the stock to stay at the same price and is neutral on DEF.