Mastering Advanced Option Concepts – Series 9

Mastering Advanced Option Concepts 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 advanced option concepts 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.

Short Stock Long Calls

An investor who sells stock short believes that they can profit from a fall in the stock price by selling it high and repurchasing it cheaper. An investor who has sold stock short is subject to an unlimited loss if the stock price should begin to rise. Once again, there is no limit to how high a stock price may rise. An investor who has sold stock short would receive the most protection by purchasing a call. A long call could be used to guard against a loss or to protect a profit on a short stock position. By purchasing the call, the investor has set the maximum price that they will have to pay to repurchase the stock for the life of the option. Before establishing a short stock long call position, the investor will have to determine:

• Their Breakeven
• Their Maximum Gain
• Their Maximum Loss

Determining The Breakeven Short Stock Long Calls

An investor who has sold stock short will profit from a fall in the stock price. When an investor has purchased a call to protect their position, the stock price must fall by enough to offset the premium the investor paid for the call. To determine the breakeven for a short stock long call position, use the following formula:

Breakeven = Stock Price – Premium

Example:
An investor establishes the following position:

Short 100 ABC at 60
Long 1 ABC October 60 call at 2

Using the above formula, we get:

60 – 2 = 58

The stock would have to fall to $58 by expiration in order for the investor to breakeven.

Maximum Gain Short Stock Long Calls

The maximum gain on the short sale of stock is always limited because a stock cannot fall below zero. When an investor has a short stock long call position, their maximum gain is found by using the following formula:

Maximum Gain = Breakeven – 0

Said another way, the investor’s maximum gain per share would be equal to their breakeven price per share. Using the same example as above, we get:

Example:
An investor establishes the following position:

Short 100 ABC at 60
Long 1 ABC October 60 call at 2

Using the above formula, we get:

58 – 0 = 58

If the stock fell to $0 by expiration, the investor would realize their maximum gain of $58 per share or $5,800 for the entire position.

Maximum Loss Short Stock Long Call

An investor who has sold stock short and has purchased a call to protect their position is only subject to a loss up to the strike price of the call. In order to determine the investor’s maximum loss, use the following formula:

Maximum Loss = Strike Price – Breakeven

Using the same example, we get:

Example:
An investor establishes the following position:

Short 100 ABC at 60
Long 1 ABC October 60 call at 2

60 – 58 = 2

The investor is subject to a loss of $2 per share or $200 for the entire position. Notice that the price at which the investor sold the stock short at and the strike price of the call are the same. As a result, the investor has set a maximum repurchase price equal to the price at which they sold the stock short. The investor’s maximum loss when the sale price and strike price are the same is the amount of the premium that the investor paid for the call. Let’s take a look at a position where the sale price of the stock and strike price of the option are different.

Example:
An investor establishes the following position:

Short 100 ABC at 56
Long 1 ABC October 60 call at 2

This investor will breakeven at $54 per share. To determine their maximum loss, subtract the breakeven from the strike price of the option.

60 – 54 = 6

The investor is subject to a loss of $6 per share or $600 for the entire position.

Short Stock Short Puts

An investor who has sold stock short can receive some protection and generate premium income by selling puts against their short stock position. Selling puts against a short stock position will only partially hedge the unlimited upside risk associated with any short sale of stock. Additionally, the investor, in exchange for the premium received for the sale of the put, has further limited their maximum gain. Before entering a short stock short put position, an investor must determine:

• Their Breakeven
• Their Maximum Gain
• Their Maximum Loss

Breakeven Short Stock Short Puts

An investor who has sold stock short and sold puts against their position is subject to a loss if the stock price begins to rise. To determine how high a stock price could rise after establishing a short stock short put position and still allow the investor to breakeven, use the following formula:

Breakeven = Stock Price + Premium

Example:
An investor establishes the following position:

Short 100 ABC at 55
Short 1 ABC November 60 call at 4

Using the above formula, we get:

55 + 4 = 59

In this case, the stock could rise to $59 by expiration and still allow the investor to breakeven excluding transaction costs.

Maximum Gain Short Stock Short Puts

An investor who has established a short stock short put position has limited the amount of their gain even further by selling puts, because the investor will be required to purchase the shares at the put’s strike price if the stock declines.

To determine the investor’s maximum gain use the following formula:

Maximum Gain = Breakeven – Strike Price

Example:
An investor establishes the following position:

Short 100 ABC at 55
Short 1 ABC November 60 call at 4

The investor will breakeven at 59 found by adding the stock price of 55 and the option premium of 4 together.

Using the above formula, we get:

59 – 4 = 54

The investor’s maximum gain in this case is $4 per share or $400 for the entire position. The investor received a total of $59 per share by establishing the position. If the stock fell to zero they would still be required to repurchase the shares at 55 under the terms of the put contract. Notice that the sales price and the put’s exercise price are the same and the amount of the investor’s maximum gain is equal to the amount of the premium received.

Let’s look at a position where the sale price of the stock and the strike price of the put are different.

Example:
An investor establishes the following position:

Short 100 XYZ at 60
Short 1 XYZ November 55 put at 4

The investor will breakeven at 64. $64 dollars per share were the total proceeds received by the investor for establishing the position.

To determine their maximum gain using the formula above, we get:

64 – 55 = 9

The investor’s maximum gain is $9 per share or $900 for the total position.

Maximum Loss Short Stock Short Puts

An investor who has sold puts against their short stock position has only limited their loss by the amount of the premium received from the sale of the put. As a result, the investor’s loss in a short stock short put position is still unlimited.

TEST POINT!
It’s important to note that any time an investor wants the most protection, they are going to buy the hedge. If the investor wants some protection and income, they will sell the hedge.