In addition to the rules and basic concept of options that the SIE exam tests on, the Series 7 will test a lot on options math itself. In other words, to work on Wall Street you need to be comfortable with what options are and how to calculate the maximum gain and loss of these derivative contracts.
Knowing what puts and calls are isn’t enough anymore; the Series 7 tests on options combinations and will ask you to figure out some pretty complicated things. Well, it looks complicated on paper; in reality, these calculations aren’t all that hard—once you know how to do them.
The Series 7 exam tests on things like straddles, combinations, and spreads, so you need to know what these are:
Straddles are when you hold the same directional positions for a call and a put (i.e., one long call and one long put or both short). They will have the same strike price and expiration date.
Combinations are when you are long or short both the call and put put they have different strike or expiration dates. (An easy way to think of this: combinations combine two different elements of options contracts, straddles literally straddle the stock’s movement up and down).
Spreads are when you are long one option and short another.
Tackling Spreads
Like direct positions on a stock, spreads can be bullish or bearish. But what makes things a bit complicated is that there are bearish call spreads and bullish put spreads, so how do you know if the spread is bullish or bearish (an important question on the Series 7 exam). Fortunately, it doesn’t matter; with spreads all that is important is that the option with the lower strike price was bought and the one with the higher strike price was sold. For instance:
Buy 1 ABC Apr 50 call at 3 Buy 1 ABC Apr 50 put at 1
Sell 1 ABC Apr 55 call at 2 Sell 1 ABC Apr 55 put at 2
These are a call and put spread, and both are bullish.
Let’s go further and calculate the maximum gain and loss for the call spread to see how the math and the process of understanding options combinations works.
For the maximum gain, we simply need to count the flow of money going in and out of our options account.
For money going in, we have a premium of $200 from selling the call. For money going out, we have a premium of $300:
Input Output
$200 $300
The result is a net debit of $1 per share.
Then we need to calculate the spread between the strike prices, which is easy: 55-50 = 5.
Now we subtract the net debit from the difference in strike prices, and we learn that our max gain is $400.
The maximum loss is even easier to calculate: with spreads (for the purposes of the Series 7, at least), we can easily calculate this because spreads are covered—the long call covers the short call, so your maximum loss is the premium paid, or $1 per share. However, this only works for symmetrical spreads (which is pretty much what the Series 7 focuses on).
Remember that uncovered short calls have unlimited max loss and uncovered short puts have strike – premium max loss.
Finally, let’s do breakeven. Again, we need the debit cost of $1 for the spread which we’ve already paid, and we need at least one option to be in the money. So we add that premium to the lower call strike price—this is how it is done with all call spreads. Thus it’s $50+$1, or $51 per share.
The put spread isn’t any harder, if you know what you’re doing.
Maximum gain is simple: the account has received $200 and paid $100 for a net credit of $100. That’s your maximum gain. for a put spread.
Maximum loss would be if ABC fell below the lower strike price, so let’s assume that happens. Let’s make a quick table to account for the money flows:
Money In Money Out
$200 $100
$5000 $5500
Remember that the $5,000 is coming in from the option to sell ABC at $50 and the option to buy ABC at $55, meaning we’re spending $5,500 and receiving $5,000 from executing these options. All told, $5,600 went out and $5,200 went in, for a max loss of $400.
For breakeven, we simply need to subtract the credit spread from the higher price (always subtract the premium received from the higher price on put spreads). Then we get $54.00 breakeven for the spread.
Calculating Straddles and Combinations
Now let’s quickly do straddles and combinations—both are easier than spreads.
Consider the following straddle:
Buy 1 ABC Apr 50 call at 3
Buy 1 ABC Apr 50 put at 2
Now let’s go for max gain, max loss, and breakeven points.
Since we’re not short anything, our max gain is the best of the max gain of the two, meaning there’s unlimited upside.
Again, we’re not short anything so our maximum loss is the premium paid: $500.
Finally, we have two breakevens. For straddles, we add the premiums together ($300 + $200) and both add them to the call premium and subtract from the put premium, giving us $55 and $45 as breakeven points.
The math here doesn’t change if you’re bullish or bearish, which makes life a little easier.
Note that the math involved is not hard! What is hard is knowing what simple adding and subtracting to do with the different kinds of options contracts, which is why it is essential to feel comfortable with options. And the only real way to be comfortable is practicing a lot of combinations of a lot of different types until it becomes second nature. Which, fortunately, takes a lot less time than you probably think it does.