How To Understand Options On The Series 4 Exam

How To Understand Options On The Series 4 Exam:
and become a Registered Options Principal

This article will help you learn how options are tested on the Series 4 exam and get you ready to pass the test. As a Registered Options Principal you must have a full understanding of a number of different option positions. This article was produced from material contained in our Series 4 textbook and will focus on how straddles are tested on the Series 4 exam.

What Multiple Option Positions and Strategies will be on the Series 4 exam?

Option strategies that contain positions in more than one option can be used effectively by investors to meet their objective and to profit from movement in the underlying stock price. The Series 4 exam will contain option questions on spreads, hedging and straddles.

What is a Long Straddle?

A long straddle is the simultaneous purchase of a call and a put on the same stock with the same strike price and expiration month. An option investor would purchase a straddle when they expect the stock price to be extremely volatile and to make a significant move in either direction. An investor who owns a straddle is neither bullish nor bearish. They are not concerned with whether the stock moves up or down in price so long as it moves significantly. An investor may purchase a straddle just prior to a company announcing earnings, with the belief that if the company beats its earnings estimate, the stock price will appreciate dramatically. Or if the company’s earnings fall short of expectations, the stock price will decline dramatically. Before an investor establishes a long straddle, they must determine the following:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Example

XYZ is trading at $50 per share and is set to report earnings at the end of the week. An investor with the above opinion establishes the following position:

Long 1 XYZ April 50 Call at 4 Long 1 XYZ April 50 Put as 3

What is the Maximum Gain on a Long Straddle?

Because the investor in a long straddle owns the calls, the investor’s maximum gain is always going to be unlimited.

What is the Maximum Loss on a Long Straddle?

An investor’s maximum loss on a long straddle is going to be limited to the total premium paid for the straddle. The total premium is found using the following formula:

Total Premium = Call Premium + Put Premium

Let’s look at an example.

Example

Long 1 XYZ April 50 Call at 4
Long 1 XYZ April 50 Put as 3

To determine the investor’s maximum loss, simply add the premiums together.

4 + 3 = 7

The investor’s maximum loss is $7 per share or $700 for the entire position. The investor will only realize their maximum loss on a long straddle if the stock price at expiration is exactly equal to the strike price of both the call and put and both options expire worthless. If, at expiration, XYZ closes at exactly $50, the investor in this case will suffer their maximum possible loss.

How do you find the Breakeven on a Long Straddle?

Because the position contains both a put and a call, the investor is going to have two breakeven points, one breakeven for the call side of the straddle and one for the put side.

To determine the breakeven point for the call side of the straddle, use the following formula:

Breakeven = Call Strike Price + Total Premium

Example

XYZ is trading at $50 per share and is set to report earnings at the end of the week. An investor with the above opinion establishes the following position:

Long 1 XYZ April 50 Call at 4
Long 1 XYZ April 50 Put as 3

Total premium = 7

50 + 7 = 57

The investor will breakeven if XYZ appreciates to $57 per share at expiration. The stock has to appreciate by enough to offset the total premium cost.

Alternatively, to determine the breakeven point for the put side of the straddle, use the following formula:

Breakeven = Put Strike Price – Total Premium

50 – 7 = 43

If XYZ was to fall to $43 per share at expiration, the investor would breakeven. The stock would have to fall by enough to offset the total premium cost. If the stock appreciated past $57 per share or was to fall below $43 per share, the position would become profitable for the investor.

FOCUS POINT!

An investor who is long a straddle wants the stock price outside of their breakeven points. In the above case, that would be either above $57 per share or below $43 per share.

What is a Short Straddle?

A short straddle is the simultaneous sale of a call and a put on the same stock with the same strike price and expiration month. An option investor would sell a straddle when they expect the stock price to trade within a narrow range or to become less volatile and not to make a significant move in either direction. An investor who is short a straddle is neither bullish nor bearish. They are not concerned with whether the stock moves up or down in price, so long as it does not move significantly. An investor may sell a straddle just after a period of high volatility, with the belief that the stock will now move sideways for a period of time. Before an investor establishes a short straddle, they must determine the following:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

What is the Maximum Gain on a Short Straddle?

An investor’s maximum gain with a short straddle is always going to be limited to the amount of the premium received. Let’s look at the same position from before; only this time, let’s look at it from the seller’s point of view.

Example

XYZ is trading at $50 and an option investor establishes the following position:

Short 1 XYZ April 50 Call at 4
Short 1 XYZ April 50 Put as 3

To determine the investor’s maximum gain, simply add the premiums together.

4 + 3 = 7

The investor’s maximum gain is $7 per share or $700 for the entire position. An investor who is short a straddle will only realize their maximum gain if the stock closes at the strike price at expiration and both options expire worthless. In this case, if XYZ closes at exactly $50, the investor will have a $700 profit on the entire position.

What is the Maximum Loss on a Short Straddle?

Because the investor in a short straddle is short the calls, the investor’s maximum loss is always going to be unlimited.

How do you find the Breakeven point on a Short Straddle?

Just like with a long straddle, the investor is going to have two breakeven points, one breakeven for the call side of the straddle and one for the put side.

To determine the breakeven point for the call side of the straddle, use the following formula:

Breakeven = Call Strike Price + Total Premium

Using the same example, we get

Example

Short 1 XYZ April 50 Call at 4
Short 1 XYZ April 50 Put as 3

Total premium = 7

50 + 7 = 57

The investor will breakeven if XYZ appreciates to $57 per share at expiration.

Alternatively, to determine the breakeven point for the put side of the straddle, use the following formula:

Breakeven = Put Strike Price – Total Premium

50 – 7 = 43

If XYZ was to fall to $43 per share at expiration, the investor would breakeven. If the stock appreciated past $57 per share or was to fall below $43 per share, the investor would begin to lose money.

FOCUS POINT!

An investor who is short a straddle wants the stock price inside of their breakeven points. In the above case, that would be either below $57 per share or above $43 per share.