Understanding Series 7 Options Questions

The Series 7 top-off exam typically includes 10-15 options questions. That’s about 10% of the 125 questions that comprise the exam. While most options questions are straightforward, you can expect a handful to demand a higher level of options skill.

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Below are three sample questions and explanations. They cover some tougher options concepts, including:

• Determining the market attitude of investors who establish spreads;
• Calculating the cost basis and gain of options transactions for tax purposes; and
• Establishing hedges in foreign currency transactions.

Type 1: Question Has a Spread, but No Premiums

In which of the following situations is the investor bullish?

A. Long XYZ 30 Put, Short XYZ 20 Put

B. Short XYZ 40 Call, Long XYZ 50 Call

C. Short XYZ 35 Put, Long XYZ 25 Put

D. Long XYZ 50 Call, Long XYZ 50 Put

Analysis: An investor has created a spread when he or she is long and short the same type of option. Whether the investor is bearish or bullish depends on which leg of the spread is dominant, and dominance is determined by the amount of premium. So, if the question gives you the premium to work with, it’s a straightforward process. Let’s assume that in choice A the investor is long the XYZ 30 put at 6 and short the XYZ 20 put at 2. Because the long put has a higher premium, it is the more dominant leg. Since buying puts is bearish, this is a bear put spread.

But with no premiums provided, as in this sample question, it’s up to you to establish which leg is dominant. To do this, just remember these basics:

• A call is an option to buy, and a low strike price is worth more to buyers. For call spreads, the leg of the spread with the lower strike price is the dominant leg.
  • If the long call in the spread has the lower strike price, the spread is bullish, because call buyers are bullish.
  • If the short call in the spread has the lower strike price, the spread is bearish, because call writers are bearish.

• A put is an option to sell, and a high strike price is worth more to sellers. For put spreads, the leg of the spread with the higher strike price is the dominant leg.
  • If the long put in the spread has the higher strike price, the spread is bearish, because put buyers are bearish.
  • If the short put in the spread has the higher strike price, the spread is bullish, because put writers are bullish.

With this in mind, let’s go through the answer choices.

A. Long XYZ 30 Put, Short XYZ 20 Put

the higher strike price has a higher premium. The investor is long the put with the higher strike, and long puts are bearish. This is a bear put spread.

B. Short XYZ 40 Call, Long XYZ 50 Call

This is a call spread, and for calls, the lower strike price has a higher premium. The investor is short the call with the lower strike price, and short calls are bearish. This is a bear call spread.

C. Short XYZ 35 Put, Long XYZ 25 Put

This is a put spread, and for puts, the higher strike price has a higher premium. The investor is short the put with the higher strike, and short puts are bullish. This is a bull put spread, so it is the right answer to the question.

D. Long XYZ 50 Call, Long XYZ 50 Put

Don’t let this one fool you! Choice D is a straddle because the investor is long both a call and a put with the same strike price. Investors who buy straddles are undecided but will profit if the market has substantial volatility in either direction.

BONUS Points: If you can determine the dominant leg of a spread, you can also determine whether the investor:

• has a debit spread or credit spread. It’s a debit spread if the investor is buying (long) the dominant leg; it’s a credit spread if the investor is selling (short) the dominant leg.
• wants the spread to widen or narrow. Investors that are buying (long) the dominant leg want the spread to widen; investors that are selling (short) the dominant leg want the spread to narrow.
• profits at exercise or expiration. Investors that are buying (long) the dominant leg profit at exercise; investors that are selling (short) the dominant leg profit at expiration.

If dominant leg is long: debit = widen = profit at exercise

If dominant leg is short: credit = narrow = profit at expiration

Although the exam questions don’t generally ask the meaning of “widening” and “narrowing,” these terms describe what happens with the difference between the premiums of the two options in the spread as they near expiration. For debit spreads, the dominant option is long, which means the investor profits from exercise of the long option. The premium of the long option will increase as the option gains value, while the premium of the short option will decrease—the difference in the premiums widens. For credit spreads, the dominant option is the short leg, which means the investor profits when the options expire. As the options near expiration and lose value, the difference in the premiums narrows.

Type 2: Options Taxation Question

An investor buys 1 ABC Jul 60 put @ 5. The put is exercised when ABC is trading for 52. What is the investor’s cost basis per share in the ABC stock and total sales proceeds from this transaction?

A. $52 cost basis, $5,500 sales proceeds

B. $47 cost basis, $5,500 sales proceeds

C. $57 cost basis, $6,000 sales proceeds

D. $52 cost basis, $6,000 sales proceeds

Analysis: Tax questions on options can be tricky because of the option premium and confusing tax terminology. One important tax term is “cost basis,” which must be determined for reporting a taxable gain or loss. The proceeds from the sale of an asset minus the cost basis result in the gain/loss that is taxable. A higher cost basis results in a lower taxable gain.

When stock is purchased as a result of exercise, the premium paid must be considered when determining the cost basis. Specifically, if stock is purchased as a result of exercise of a long call, the premium is added to the strike price to determine the cost basis of the stock. But when stock is purchased by a put writer due to exercise of the put, the premium received is subtracted from the strike price to determine the cost basis of the stock.

In this question, the investor bought a put, which permits sale of stock at the price of $60. Since the investor isn’t purchasing the stock through options exercise, the premium is not a factor in determining the cost basis. Here, cost basis is simply the price the investor paid to acquire the stock that was sold. Because the question does not specify that the customer already owned the stock, assume it must be purchased at the current market value. The price paid for the stock is the current market value of $52 per share, which is also the cost basis for tax purposes.

The sales proceeds are determined by reducing the $6,000 received in the sale by the premium paid of $500. The sales proceeds are $5,500. Answer A is correct.

BONUS Points: If the question had asked for the taxable gain, it could be calculated by subtracting the cost basis from the sales proceeds. The taxable gain in this transaction is $300.

Type 3: Foreign Currency Hedging Question

A French company exports wine to the United States and will receive payment in US dollars. How can the exporter best hedge against an adverse movement in the Euro?

A. Buy calls on the US dollar

B. Buy calls on the Euro

C. Buy puts on the Euro

D. Sell puts on the Euro

Analysis: When you encounter an options question involving import/export and foreign currency, a crucial point to remember is that there are no options on the US dollar. So you must balance the attitude toward the dollar with the attitude toward the foreign currency. If you want a strong dollar, you want a weak foreign currency, and vice versa.

In this question, the exporter will be paid in dollars so it would benefit from a strong dollar, making the exporter bullish on the dollar. If bullish on the dollar, the exporter is bearish on the Euro. But there is one more important step: The question is asking how to hedge or protect, which means you must insure the position with an option that will benefit if the market goes against the exporter. We have established that the exporter is bearish on the Euro, so it would want to protect with a bullish position (this benefits the exporter if the market moves in the wrong direction). Buying calls on the Euro is the best protection, making the answer to this question B.

To summarize, in a foreign currency hedging question, establish the market direction you want for the foreign currency, then do the opposite to protect.

BONUS Points: In a hedging question, the best protection, or a full hedge, is accomplished by buying an option. Selling an option provides only a small amount of protection – just the premium received. So selling an option is not a “full” hedge; it’s only partial protection.

Next Steps

If you haven’t mastered the basics of options, take the time to review your study materials and complete more options practice questions. You can access great resources to learn more about options strategies and calculations in the Training Center at www.Knopman.com. Keep practicing, and even the tough Series 7 options questions will go well for you!