Understanding Options – Series 9

Understanding Options On The Series 9 Exam

One of the keys to passing the Series 9 exam is to make sure that you have a complete understanding of how options will be tested on the Series 9 Exam. This article which was produced from material contained in our Series 9 textbook and will help you master the material so that you pass the Series 9 exam.

Characteristics of All Options

All standardized option contracts are issued and their performance is guaranteed by the Options Clearing Corporation (The OCC). Standardized options trade on the exchanges such as the Chicago Board Options Exchange and the NYSE Alternext.

All option contracts are for one round lot of the underlying stock or 100 shares. To determine the amount that an investor either paid or received for the contract, take the premium and multiply it by 100. If an investor paid $4 for 1 KLM August 70 call, they paid $400 for the right to buy 100 shares of KLM at $70 per share until August. If another investor paid $2 for 1 JTJ May 50 put, they paid $200 for the right to sell 100 shares of JTJ at $50 until May.

Managing an Option Position

Both the buyer and seller, in an option trade, establish the position with an opening transaction. The buyer has an opening purchase and the seller has an opening sale. To exit the option position, an investor must “close out” the position. The buyer of the option may exit their position through:

• A Closing Sale
• Exercising The Option
• Allowing The Option To Expire

The Seller of an option may exit or close out their position through:

• A Closing Purchase
• Having the Option Exercised or Assigned to Them
• Allowing The Option to Expire

Most individual investors do not exercise their options and will simply buy and sell options in much the same way as they would buy or sell other securities.

Buying Calls

An investor who purchases a call believes that the underlying stock price will rise and that they will be able to profit from the price appreciation by purchasing calls. An investor who purchases a call can control the underlying stock and profit from its appreciation while limiting their loss to the amount of the premium paid for the calls. Buying calls allows the investor to maximize their leverage and they may realize a more significant percentage return based on their investment. An investor may also elect to purchase a call to lock in a purchase price for a security if the investor currently lacks the funds required to purchase the security but will have the funds available in the near future. When looking to establish a position the buyer must determine:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Maximum Gain Long Calls

When an investor has a long call position, their maximum gain is always unlimited. They profit from a rise in the stock price. Since there is no limit to how high a stock price may rise, their maximum gain is unlimited just as if they had purchased the stock.

Maximum Loss Long Calls

Whenever an investor is long, or owns a stock, their maximum loss is always limited to the amount they invested. When an investor purchases a call option, the amount they pay for the option or their premium is always going to be their maximum loss.

Determining The Breakeven for Long Calls

An investor who has purchased calls must determine where the stock price must be at expiration in order for the investor to breakeven on the transaction. An investor who has purchased calls has paid the premium to the seller in the hopes that the stock price will rise. The stock must appreciate by enough to cover the cost of the investor’s option premium in order for them to breakeven at expiration. To determine an investor’s breakeven point on a long call use the following formula:

Breakeven = Strike Price + Premium

Example:

An investor has established the following option position:

Long 1 XYZ May 30 call at 3

The Investor’s maximum gain, maximum loss, and breakeven will be:

Maximum Gain: Unlimited
Maximum Loss $300 (The amount of the premium paid)
Breakeven: $33 = 30 + 3 (Strike price + premium)

If at expiration XYZ is at exactly $33 per share and the investor sells or exercises their option they will breakeven excluding transactions costs.

Selling Calls

An investor who sells a call believes that the underlying stock price will fall and that they will be able to profit from a decline in the stock price by selling calls. An investor who sells a call is obligated to deliver the underlying stock if the buyer decides to exercise the option. When looking to establish a position, the seller must determine:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Maximum Gain Short Calls

For an investor who has sold uncovered or naked calls, maximum gain is always limited to the amount of the premium they received when they sold the calls.

Maximum Loss Short Calls

An investor who has sold uncovered or naked calls does not own the underlying stock and, as a result, has unlimited risk and the potential for an unlimited loss. The seller of the calls is subject to a loss if the stock price increases. Since there is no limit to how high a stock price may rise, there is no limit to the amount of their loss.

Determining The Breakeven for Short Calls

An investor who has sold calls must determine where the stock price must be at expiration in order for the investor to breakeven on the transaction. An investor who has sold calls has received the premium from the buyer in the hopes that the stock price will fall. If the stock appreciates, the investor may begin to lose money. The stock price may appreciate by the amount of the option premium received and the investor will still breakeven at expiration. To determine an investor’s breakeven point on a short call, use the following formula:

Breakeven = Strike Price + Premium

Example:

An investor has established the following option position:

Short 1 XYZ May 30 call at 3

The Investor’s maximum gain, Maximum loss, and breakeven will be:

Maximum Gain: $300 (The amount of the premium received)
Maximum Loss: Unlimited
Breakeven: $33 = 30 + 3 (Strike price + premium)

If at expiration XYZ is at exactly $33 per share and the investor closes out the transaction with a closing purchase or has the option exercised against them, they will breakeven excluding transactions costs.

Notice the relationship between the buyer and the seller:

Because an option is a two-party contract, the buyer’s maximum gain is the seller’s maximum loss and the buyer’s maximum loss is the seller’s maximum gain. Both the buyer and the seller will breakeven at the same point.