In Tips For Series 7 Options Questions, we discussed "pure" options strategies. Here, we will focus on the considerable number of questions on the Series 7 exam that test the candidates on strategies involving both options contracts and stock positions. (For everything you need to know for the Series 7 exam, see our Free Series 7 Online Study Guide.)
Solving "Mixed" Options Strategy Problems
The first strategy to use in solving these questions is deceptively simple: Read the questions carefully to determine the customer's primary objective:
- If the question indicates that a customer needs to protect a stock position, then he or she must buy an options contract for protection.
- If the customer is combining options with stock positions to create income, he or she must sell an options contract to produce the income.
As with the majority of options questions on the Series 7 exam, the scope of the questions is limited to maximum gain, maximum loss and breakeven. (To learn more, read Option Spread Strategies and Options Basics.)
A tool that you should use each time you calculate any of these is the $OUT/$IN cross. Don't take a chance by trying to keep track of the money flow in your head. The Series 7 exam is quite stressful for most people, so just write it down.
|$ Out||$ In|
A special note: In any strategy that combines stock with options, the stock position takes precedence. This is because options contracts expire - stocks do not.
Protecting Stock Positions: Hedging
Let's begin with hedging strategies. We will look at long hedges and short hedges. In each case, the name of the hedge indicates the underlying stock position. The options contract is a temporary form of insurance to protect the investor's stock position against adverse movements in the market. (For related reading, see A Beginner's Guide To Hedging.)
Long Hedges = Long Stock and Long Put
A long stock position is bullish. If the market in a stock turns down, the investor with the long stock position loses. Remember: If an investor needs to protect a stock position with options, the investor must buy the contract (like an insurance contract) and pay a premium. Puts go in-the-money (become exercisable) when the stock's market price falls below the strike price. The put is an insurance policy for the investor against a drop in the market. (To read more, check out Prices Plunging? Buy A Put! and Introduction To Put Writing.)
Let's look at few sample questions that illustrate one of the many approaches the exam may take to this subject. For these examples, we'll be changing only the multiple choice options that could be provided for the same question.
A registered representative has a customer who bought 100 shares of XYZ stock at $30/share. The stock has appreciated to $40/share in the past eight months.The investor is confident that the stock is a good long-term investment with additional upside potential but is concerned about a near-term weakness in the overall market that could wipe out his unrealized gains. Which of the following strategies would probably be the best recommendation for this customer?
A. Sell calls on the stock
B. Buy calls on the stock
C. Sell puts on the stock
D. Buy puts on the stock
Explanation: This is a basic strategy question. The customer wishes to fix, or set, his selling price for the stock. When he buys puts on the stock, the selling (or delivery) price for the stock is the strike price of the put until expiration. The long stock position is bullish, so to counter a downward movement, the investor purchases puts. Long puts are bearish.
Now, using the same question, let\'s look at a different set of answers.
Let's try some others.
An investors buys 100 shares of XYZ stock at $30/share and one XYZ 40 put @ 3 to hedge the position. Over eight months, the stock appreciates to $40/share.The investor is confident that the stock is a good long-term investment with additional upside potential, but is concerned about a near-term weakness in the overall market that could wipe out his unrealized gains. What is the maximum gain for this investor?
Now let's take a different look at this question:
An investors buys 100 shares of XYZ stock at $30/share and one XYZ 40 put @ 3 to hedge the position. The stock has appreciated to $40/share in the past eight months.The investor is confident that the stock is a good long-term investment with additional upside potential but is concerned about a near-term weakness in the overall market that could wipe out his unrealized gains. If XYZ stock drops to $27 and the investor exercises the put, what is the profit or loss on the hedged position?
Here's another common approach to this type of question:
An investors buys 100 shares of XYZ stock at $30/share and one XYZ 40 put @ 3 to hedge the position. The stock has appreciated to $40/share in the past eight months. The investor is confident that the stock is a good long-term investment with additional upside potential, but is concerned about a near-term weakness in the overall market that could wipe out his unrealized gains. What is the investor\'s breakeven point for this position?
Now, let's look at the other side of the market.
Short Hedges = Short Stock and Long Call
We noted above that the stock position takes precedence. Remember: When an investor sells stock short, he or she expects the market in that stock to fall. If the stock rises, the investor theoretically has an unlimited loss. To insure themselves, investors may buy calls on the stock. The short stock position is bearish. The long call is bullish.
An investor who sells stock short is obligated to replace the stock. If the stock price rises, the investor loses. The investor buys a call to set (or fix) the purchase price. Until the options contract expires, the investor will pay no more than the call's strike price for the stock. (To learn more, read the Short Selling tutorial.)
Suppose that an investor has sold 100 shares of MNO stock short at $75/share and feels confident that the stock\'s price will fall in the market in the near future. To protect against a sudden rise in price, a registered representative would recommend which of the following?
Now let's try a different approach.
An investor has sold 100 shares of FBN stock short at 62 and buys one FBN Jan 65 call @ 2. If FBN stock rises to 70 and the investor exercises the call, what is the gain or loss in this position?
Recap: As you can see, the long and short hedges are mirror image strategies. Remember, the stock position takes precedence and the investor must pay a premium (buy a contract) to protect the stock position. If the question refers to protection, hedging is the strategy.
Covered Call = Long Stock Plus Short Call
Writing (selling) covered calls is the most conservative of options strategies. Recall that when an investor sells a call, he or she is obligated to deliver the stock at the strike price until the contract expires. If the investor owns the underlying stock, then he or she is "covered" and can deliver if exercised.
The Series 7 exam may give you a hint by using the word, "income", as in Example 8, below.
An investor owns 100 shares of PGS. The stock has been paying regular dividends but has shown very little growth potential. If the investor is interested in creating income while reducing risk, the registered representative should recommend which of the following strategies?
Let's add some numbers to the situation and ask some additional questions:
The investor is long 100 shares PGS at $51 and writes one PGS May 55 call @ 2. What is the investor\'s maximum gain from this strategy?
Take the same situation as in Example 9 and ask the question: What is the investor\'s breakeven point?
A covered call increases income and reduces risk. Those are the two objectives of this conservative strategy. The strategy works best in a relatively flat to slightly bullish market. Investors must be made aware that:
- There is a limited gain.
- The stock may be called away.
Short Stock Plus Short Put
Another, and much riskier, strategy involves writing a put when the investor has a short position in the same stock. This position is a very bearish strategy. Remember, the stock position takes precedence.
An investor sells 100 shares MPS short at 70 and simultaneously writes one MPS 70 put @ 3. What is the maximum gain in this strategy?
Another question regarding this scenario: What is the maximum loss?
On the Series 7 exam, there are relatively few questions on this strategy. Recognize, however, the maximum gain, maximum loss and breakeven - just in case.
Options with stock positions have two basic objectives:
1. Protection of the stock position through hedging
2. Creating income by selling an option against the stock position.
The strategies outlined here may be either highly risky or very conservative. In the Series 7 exam, the candidate must first recognize which strategy recommendation is required and then follow the money to find the correct answer. (For everything you need to know for the Series 7 exam, see our Free Series 7 Online Study Guide.)