Section 3
Function 3: Investment Products, Recommendations & Records
Options
82 min read
· Lesson 13 of 19
About This Lesson
Options are the single largest topic on the Series 7, and the exam tests them mechanically, not conceptually: you will compute breakevens, max gain, max loss, and P&L at expiration, over and over, for every strategy in the book. The good news is that the whole edifice rests on four basic positions; every spread, straddle, and hedge is just those four bricks in combination.
What you'll cover
- fundamentals: contract terms, the four P&L profiles, moneyness, intrinsic versus time value, and the PIT identity
- strategies: spreads, straddles, collars, the four stock-plus-option hedges, covered and ratio writing, with worked P&L math and a strategy calculator
- machinery and rules: the OCC, assignment, settlement times, LEAPS, index, yield-based and currency options, the taxation table, and the account-approval sequence
This is the thirteenth chapter of the products module and the second-longest in the course; like packaged products, it rewards two sittings.
Section 1 of 5
~10 min · 2 concept checks
Options Fundamentals
Options Fundamentals: Rights, Obligations, and Terminology
An option is a contract that gives the buyer the right (but not the obligation) to buy or sell an underlying security at a specified price (the strike price) on or before a specified date (expiration). The seller (writer) has the obligation to perform if the buyer exercises.
Long call
Right to BUY at strike
Premium
Pays premium
Max gain
Unlimited
Max loss
Premium paid
Short call
Obligation to SELL at strike
Premium
Receives premium
Max gain
Premium received
Max loss
Unlimited
Long put
Right to SELL at strike
Premium
Pays premium
Max gain
Strike − premium
Max loss
Premium paid
Short put
Obligation to BUY at strike
Premium
Receives premium
Max gain
Premium received
Max loss
Strike − premium
Intrinsic value vs. time value:
- Intrinsic value: The in-the-money amount. Call intrinsic value = Stock price − Strike price (when positive). Put intrinsic value = Strike price − Stock price (when positive).
- Time value: Premium − Intrinsic value. Decays as expiration approaches (theta decay). An at-the-money option is 100% time value.
The Four Basic P&L Profiles
Long call
Bullish. Profits when stock rises above breakeven. Loss limited to premium paid.
Breakeven = Strike + Premium
Max gain = Unlimited
Max loss = Premium paid
Max gain = Unlimited
Max loss = Premium paid
Long put
Bearish. Profits when stock falls below breakeven. Loss limited to premium paid.
Breakeven = Strike − Premium
Max gain = Strike − Premium (stock → $0)
Max loss = Premium paid
Max gain = Strike − Premium (stock → $0)
Max loss = Premium paid
Short call (naked)
Bearish/neutral. Profits if stock stays below strike. Unlimited risk if stock soars.
Breakeven = Strike + Premium
Max gain = Premium received
Max loss = Unlimited
Max gain = Premium received
Max loss = Unlimited
Short put
Bullish/neutral. Profits if stock stays above strike. Risk if stock falls sharply.
Breakeven = Strike − Premium
Max gain = Premium received
Max loss = Strike − Premium (stock → $0)
Max gain = Premium received
Max loss = Strike − Premium (stock → $0)
Concept Check
An investor buys 1 XYZ call option with a strike price of $50 and pays a premium of $3. At expiration, XYZ is trading at $56. What is the investor's profit or loss?
At expiration with the stock at $56, the call with a $50 strike has intrinsic value of $56 − $50 = $6. The investor paid $3 premium, so the net profit is $6 − $3 = $3 per share ($300 per contract of 100 shares). The breakeven for a long call is always strike + premium = $50 + $3 = $53. At $56, the investor is $3 above breakeven.
Concept Check
Which of the following options strategies has unlimited maximum risk?
A naked (uncovered) short call has unlimited risk because the writer is obligated to sell shares at the strike price — but if the stock rises without limit, the cost to acquire those shares (or the loss on the position) is theoretically unlimited. A long call has limited risk (premium paid). A long put has limited risk (premium paid). A covered call has limited but definable risk — the writer owns the underlying stock, so the short call is covered and the unlimited upside risk is offset.
Section 2 of 5
~14 min · 5 concept checks
Spreads, Straddles & Strategy ID
Spreads, Straddles, and Collars
Vertical Spreads
A spread involves buying and selling options of the same type (both calls or both puts) on the same underlying with different strikes or expirations. Both the maximum gain and maximum loss are limited.
Bull call spread
Moderately bullish
Buy lower strike call, sell higher strike call
Gain: strike diff − debit
Loss: net debit paid
Bear put spread
Moderately bearish
Buy higher strike put, sell lower strike put
Gain: strike diff − debit
Loss: net debit paid
Bull put spread
Moderately bullish
Sell higher strike put, buy lower strike put
Gain: net credit received
Loss: strike diff − credit
Bear call spread
Moderately bearish
Sell lower strike call, buy higher strike call
Gain: net credit received
Loss: strike diff − credit
Straddles and Strangles
- Long straddle: Buy call and put at the same strike. Profitable when the stock moves significantly in either direction. Net premium is total cost; the stock must move enough to exceed both premiums to profit.
- Short straddle: Sell call and put at the same strike. Maximum profit is both premiums collected; profitable when the stock barely moves. Unlimited risk in both directions.
- Long strangle: Buy out-of-the-money call and put (different strikes). Cheaper than a straddle but requires a larger move to be profitable.
Covered Call and Protective Put
- Covered call: Own stock + sell call. Generates income but caps upside. Breakeven = Stock cost − Call premium. Not bearish — neutral to mildly bullish.
- Protective put: Own stock + buy put. Provides downside insurance. Breakeven = Stock cost + Put premium. Hedged bullish strategy.
- Collar: Own stock + sell call + buy put. Both hedges the downside (put) and caps upside (short call). Often structured for near-zero net cost.
Worked Examples: Options P&L Step-by-Step
Problem 1 — Bull call spread: An investor buys 1 XYZ 50 call for $4 and sells 1 XYZ 60 call for $1.50. Net debit = $2.50. Calculate: (a) maximum gain, (b) maximum loss, (c) breakeven, and (d) profit/loss if XYZ expires at $57.
1
Net debit = Premium paid − Premium received
$4.00 − $1.50 = $2.50 per share ($250 per contract)2
Maximum loss = Net debit (both options expire OTM)
$2.50 per share — occurs if XYZ ≤ $50 at expiration3
Maximum gain = Spread width − Net debit
Occurs when XYZ ≥ $60 at expiration (both options ITM, capped by short call)
($60 − $50) − $2.50 = $10 − $2.50 = $7.50 per shareOccurs when XYZ ≥ $60 at expiration (both options ITM, capped by short call)
4
Breakeven = Lower strike + Net debit
$50 + $2.50 = $52.505
P&L at $57: Long 50 call worth $7 (57−50). Short 60 call expires worthless.
Net value = $7.00. Profit = $7.00 − $2.50 cost =
Net value = $7.00. Profit = $7.00 − $2.50 cost =
$4.50 per share(a) Max gain = $7.50 | (b) Max loss = $2.50 | (c) Breakeven = $52.50 | (d) Profit at $57 = $4.50 per share ($450/contract).
Problem 2 — Long straddle: An investor buys 1 XYZ 75 call for $5 and 1 XYZ 75 put for $4. Total debit = $9. Calculate: (a) both breakevens, (b) maximum gain, (c) maximum loss, and (d) P&L if XYZ expires at $68.
1
Total premium paid = $5 + $4 =
$9 per share2
Upside breakeven = Strike + Total premium
$75 + $9 = $843
Downside breakeven = Strike − Total premium
$75 − $9 = $664
Maximum gain = Unlimited to the upside (call gains as stock rises). Downside limited to strike − premium =
$75 − $9 = $66 if stock goes to zero.5
Maximum loss = Total premium paid =
$9 per share — occurs if stock expires exactly at $75 (both options worthless).6
P&L at $68: Call expires worthless. Put is ITM: worth $75 − $68 = $7.
Net value = $7. Loss = $7 − $9 cost =
$68 is between the two breakevens ($66 and $84) → position loses money.
Net value = $7. Loss = $7 − $9 cost =
−$2 per share (loss of $200)$68 is between the two breakevens ($66 and $84) → position loses money.
(a) Breakevens: $66 and $84 | (b) Max gain: unlimited up, $66/share down | (c) Max loss: $9 | (d) Loss of $2/share at $68.
Problem 3 — Covered call: An investor bought 100 shares of ABC at $55. She sells 1 ABC 60 call for $3 premium. Calculate: (a) breakeven, (b) maximum gain, (c) maximum loss, and (d) outcome if ABC rises to $70 at expiration.
1
Effective cost basis = Stock cost − Call premium
$55 − $3 = $52 per share2
Breakeven = Effective cost basis =
(The $3 premium received lowers the breakeven by $3.)
$52(The $3 premium received lowers the breakeven by $3.)
3
Maximum gain = Strike price − Effective cost basis
Capped at $60 because the short call obligates her to sell at $60.
$60 − $52 = $8 per share ($800 per contract)Capped at $60 because the short call obligates her to sell at $60.
4
Maximum loss = Effective cost basis = $52 per share
(If the stock falls to $0, she loses $55 paid − $3 premium received = $52.)
(If the stock falls to $0, she loses $55 paid − $3 premium received = $52.)
5
Outcome at $70: The 60 call is exercised against her — she must sell 100 shares at $60 (not $70).
Gain on stock: $60 − $55 = $5. Plus premium: $3. Total = $8 per share. She misses the move from $60 to $70.
Gain on stock: $60 − $55 = $5. Plus premium: $3. Total = $8 per share. She misses the move from $60 to $70.
(a) Breakeven = $52 | (b) Max gain = $8/share | (c) Max loss = $52/share | (d) Gain = $8/share at $70 (capped — misses $10 upside above $60).
Tool Card: Options Calculator
Build any of the 12 core options strategies interactively — select a strategy, enter the strike prices and premiums, and see the full P&L chart with breakeven, maximum gain, and maximum loss calculated automatically.
Open Options Calculator
Build any of the 12 core options strategies interactively — select a strategy, enter the strike prices and premiums, and see the full P&L chart with breakeven, maximum gain, and maximum loss calculated automatically.
Open Options Calculator
Interactive: Options Strategy Outlook Sorter
Score: 0 / 6
Tap a strategy, then tap the matching market outlook.
Sort each strategy by the investor's market outlook
Bullish
Bearish
Neutral / low volatility
Concept Check
An investor buys 1 XYZ straddle — purchasing a call and a put at a $60 strike. The call premium is $4 and the put premium is $3. What are the breakeven points for this position?
A long straddle has two breakeven points. Total premium paid = $4 + $3 = $7. Upside breakeven = Strike + Total premium = $60 + $7 = $67. Downside breakeven = Strike − Total premium = $60 − $7 = $53. The investor profits if the stock moves above $67 or below $53. Within this range, the position loses money, with maximum loss equal to the total premium ($700) if the stock is exactly at $60 at expiration.
Concept Check
An investor buys a bull call spread: buys 1 XYZ 45 call for $5 and sells 1 XYZ 55 call for $2. Net debit = $3. What are the maximum gain and maximum loss for this position?
Bull call spread: buy 45 call ($5) + sell 55 call ($2) = net debit of $3. Maximum loss = net debit = $3 (both options expire worthless, stock below 45). Maximum gain = spread width − net debit = ($55 − $45) − $3 = $10 − $3 = $7 (stock above 55 at expiration, both options in the money, the gain is capped). Breakeven = lower strike + net debit = $45 + $3 = $48.
Concept Check
An investor holds a bear put spread: bought 1 XYZ 60 put for $5 and sold 1 XYZ 50 put for $2. Net debit is $3. The stock falls to $45 at expiration. What is the investor's profit or loss?
Bear put spread: buy higher strike put (60), sell lower strike put (50). Net debit = $5 - $2 = $3. At expiration with stock at $45, both puts are in the money. The 60 put is worth $15 (60-45), the 50 put is worth $5 (50-45). Net position value = $15 - $5 = $10. Profit = $10 - $3 cost = $7. Maximum gain = spread width - net debit = $10 - $3 = $7 (achieved when stock is at or below the lower strike). Breakeven = 60 - 3 = 57.
Concept Check
An investor buys an XYZ 45 call for $3 and sells an XYZ 55 call for $1 (bull call spread, net debit $2). At expiration, XYZ is at $50. What is the result?
At expiration with XYZ at $50: the 45 call is worth $5 (in the money), the 55 call expires worthless (out of the money). Net value = $5. Profit = $5 - $2 net debit = $3 per share. The maximum gain ($8) only occurs when the stock is at or above $55 — when both the long 45 call and short 55 call are in the money. Breakeven = 45 + 2 = $47. At $50 the investor is above breakeven but has not yet hit the maximum.
Concept Check
An investor simultaneously buys 1 XYZ Nov 70 put and sells 1 XYZ Nov 60 put when XYZ is selling for $65. This position is best described as
This is a put spread because both legs are puts. The investor bought the higher-strike put (more valuable, since a higher strike means the right to sell at a better price) and sold the lower-strike put, creating a debit put spread. Debit put spreads are bearish — the investor profits if XYZ falls, with maximum gain at the lower strike. Bull spreads pay out on price increases, combinations mix puts and calls at different strikes, and a straddle pairs a put and a call at the same strike.
Section 3 of 5
~10 min · 4 concept checks
Covered Writing & Stock-Plus-Option Hedging
The Four Stock-Plus-Option Hedging Combinations
Pair a stock position with an option and you have a hedge. Four combinations exist, and the exam expects instant recognition of all four:
Long stock + Long put
Protective put
Long the underlying, buys a put as downside insurance. Maintains upside; caps loss to (stock cost − strike) + premium. Bullish with hedge.
Long stock + Short call
Covered call
Long the underlying, writes a call to generate income. Caps upside at the strike; partially cushions downside by the premium. Neutral to mildly bullish.
Short stock + Long call
Hedged short
Short seller buys a call to cap the unlimited upside risk on the short. Best matched to the strike near current price for tight protection. Bearish with hedge.
Short stock + Short put
Covered put
Short seller writes a put to collect a premium. The short stock provides cash to satisfy the put if assigned. Caps the bearish upside; partial protection equal to put premium received.
"Covered put" naming trap: The
term refers to a short stock + short put position — not a put writer who has
cash on hand. The "covering" comes from the short stock providing the resources
to fulfill the put obligation if assigned. Customers (and exam writers) commonly
confuse this with cash-secured put writing.
Hedging principle: A hedge always
pairs a stock position with an opposite-sentiment option position. Long stock
is bullish; pair with a bearish option (long put or short call). Short stock is bearish;
pair with a bullish option (long call or short put).
Concept Check
An investor who owns 100 shares of ABC at $45 sells 1 ABC call option with a strike of $50 for a premium of $3. This strategy is called a covered call. What is the investor's maximum gain per share?
In a covered call, the maximum gain is capped when the stock reaches the strike price. At $50, the short call is exercised and the investor sells shares at $50. Gain from stock = $50 − $45 = $5, plus $3 premium received = $8 total gain per share. Above $50, the call obligates the investor to sell at $50, capping further participation in the stock's rise. Breakeven = $45 cost − $3 premium = $42.
Concept Check
Which of the following most accurately describes a protective put?
A protective put involves buying a put option against a long stock position. The put provides insurance — if the stock falls below the strike price, the put gains value, offsetting the stock loss. The investor keeps full upside participation in the stock (unlike a covered call, which caps the upside). The cost is the put premium, which raises the breakeven: stock purchase price + put premium = breakeven. Protective puts are the most direct hedge against downside risk for a stockholder.
Concept Check
Covered put writing is best described as a strategy in which an investor
A covered put pairs a short stock position with a short put. The short stock provides cash to satisfy the put if assigned — the investor will buy back the shares at the put’s strike, closing both legs simultaneously. Writing a put while holding stock long is the opposite sentiment and does not offset; pairing a short put with a short call creates a short combination, not a covered position. Cash-secured put writing (cash on hand to fund a potential assignment) is a related but distinct strategy and is not what "covered" refers to in this context.
Concept Check
A customer is short 100 shares of DFI at $35 and now believes a near-term rally is possible. Of the following, which strategy would best hedge the short position against an upside move?
A short stock position is bearish, so the hedge requires a bullish option — either a long call or a short put. The 35-strike call provides immediate protection: if DFI rallies, the call gains intrinsic value above 35, offsetting the loss on the short stock. A 40-strike call only kicks in after DFI rises five points beyond the short, leaving an unhedged gap. Writing a call adds risk rather than hedging; writing a put is bullish but provides only premium-sized protection, far less than a long call near the current price.
Section 4 of 5
~12 min · 2 concept checks
Greeks, Moneyness & Market Data
Options Greeks: Delta, Theta, and Vega
The Greeks measure how an option's price changes in response to various factors. The Series 7 tests conceptual understanding, not precise calculations.
Delta
Measures
Price change per $1 move in underlying
Exam application
Deep ITM → delta ≈1.0. ATM → ≈0.50. Hedge ratio = 1/delta.
Theta
Measures
Time value decay per day
Exam application
Hurts buyers, helps sellers. Accelerates near expiration. ATM decays fastest.
Vega
Measures
Sensitivity to implied volatility changes
Exam application
Higher vol = higher premiums. Benefits buyers, hurts sellers. Earnings inflate vega.
Moneyness and Trading at Parity
Three moneyness terms and one premium relationship carry this section, and the relationship doubles as a near-expiration signal:
In the money (ITM)
Has intrinsic value
Call: stock price > strike. Put: stock price < strike. The buyer would gain by exercising; the writer is at risk of assignment.
At the money (ATM)
Stock = strike
Calls and puts are both at the money when the stock price equals the strike price. Intrinsic value is zero; the entire premium is time value.
Out of the money (OTM)
No intrinsic value
Call: stock price < strike. Put: stock price > strike. Premium is entirely time value. The buyer needs the stock to move to profit.
The PIT Identity and Trading at Parity
Premium = Intrinsic value + Time value → rearranged: Time value = Premium − Intrinsic value
(memorize as PIT)
An option trades at parity when premium equals intrinsic value, which is another way of saying the time value has hit zero. You will mostly see it at or near expiration, when there is no time left for the stock to move.
Worked example: A customer holds an XYZ Feb 35 put bought at a
premium of 5. XYZ is currently trading at $33, and the put’s current premium is $2.
Intrinsic value = $35 strike − $33 stock = $2.
Time value = $2 premium − $2 intrinsic = $0.
The option is trading at parity. The original $5 cost paid for the contract is irrelevant to the parity determination — it only matters when computing gain or loss at sale or expiration.
Intrinsic value = $35 strike − $33 stock = $2.
Time value = $2 premium − $2 intrinsic = $0.
The option is trading at parity. The original $5 cost paid for the contract is irrelevant to the parity determination — it only matters when computing gain or loss at sale or expiration.
Terminology trap: "In the money"
and "out of the money" describe the option, not the investor.
An ITM call benefits the long holder and harms the short writer — but the option
itself is still simply ITM. The exam frequently tries to confuse this distinction.
Open Interest, Put-Call Ratio, and Ratio Call Writing
Open Interest
Open interest counts every options contract in a series that is still open. Daily volume counts what traded today; open interest counts what remains outstanding. An opening transaction adds 1, a closing transaction subtracts 1.
Put-Call Ratio
The put-call ratio is put volume divided by call volume, read as a sentiment gauge:
- High ratio (more puts than calls) signals bearish sentiment.
- Low ratio (more calls than puts) signals bullish sentiment.
- Some practitioners use the ratio as a contrarian indicator — extreme bearishness can mark a market bottom and vice versa.
Ratio Call Writing
Ratio call writing means owning stock and writing more calls than the shares cover. The covered portion behaves like a covered call; the excess calls are naked, and naked calls carry unlimited upside risk.
Example: An investor owns 500 shares of XYZ and writes 8 XYZ calls.
Five of the eight calls are covered by the 500 shares (each contract = 100 shares).
The remaining three calls are naked. If XYZ rallies sharply, the
investor must deliver 800 shares against the calls but owns only 500 — forcing
open-market purchases at potentially much higher prices to cover the naked portion.
Margin and approval: Ratio call
writing requires the highest level of options approval and a margin account because
of the uncovered call exposure. It is generally not suitable for inexperienced or
risk-averse customers.
Concept Check
Which of the following options positions has the greatest sensitivity to time decay (theta)?
Theta (time decay) accelerates dramatically as expiration approaches, especially for at-the-money options. An ATM option with 2 weeks to expiration experiences the fastest rate of time value erosion — the entire remaining premium is time value, and each day removes a proportionally larger fraction of it. Deep ITM options have little time value left to decay. Deep OTM options have small absolute premium amounts. Long-dated options decay slowly in absolute terms. ATM near-expiration is the maximum theta scenario.
Concept Check
A customer holds an XYZ Feb 35 put bought several months ago at a premium of 5. XYZ is currently trading at $33, and the put’s current premium is $2. The option is trading
An option trades at parity when its premium equals its intrinsic value, leaving zero time value. The intrinsic value of a 35 put with the stock at $33 is the $2 in-the-money amount; the current premium is also $2, so time value is zero and the option is at parity. This typically occurs at or very near expiration. The put is in the money (stock below strike), not out of the money or at the money. The original $5 purchase premium is not relevant to the parity determination — it matters only when computing the customer’s gain or loss at sale or expiration.
Section 5 of 5
~18 min · 3 concept checks
Special Types, Taxation & Account Mechanics
The OCC, Assignment, and Settlement
The Options Clearing Corporation (OCC) issues and guarantees every listed option in the United States. The moment a trade matches on an exchange, the OCC becomes the buyer to every seller and the seller to every buyer; counterparty risk leaves the picture, and contract terms stay standardized.
Assignment of Exercise Notices
When a holder exercises, the OCC has to find a short to assign, and the exam tests the two-step path precisely:
1
OCC → Clearing firm: random
The OCC selects a clearing firm with a short position at random from all firms holding open short contracts in that series.
2
Clearing firm → customer: random OR FIFO
The clearing firm then assigns the exercise to a specific customer using one of two approved methods: random, or first-in, first-out (FIFO). The firm must disclose its allocation method to each customer in writing at account opening.
Settlement Times (Current Rules)
Equity option premium
T+1
Premium settles next business day after the trade.
Equity option exercise
Stock delivers T+1
Underlying shares deliver one business day after exercise notice (since May 2024 SEC T+1 rule).
Index option exercise
Cash next business day
No physical delivery — the writer pays the holder cash equal to the in-the-money amount, settled the next business day.
FCO exercise
Cash settled, USD
All FCOs settle in U.S. dollars regardless of currency — settlement timing follows the contract’s terms.
Textbook update: Some study
materials still reference the pre-2024 rule that equity option exercises settled
T+2. The current rule is T+1, effective May 28, 2024. Index options
remain cash settled the next business day.
The LEAPS and Index Options Distinctions
LEAPS (Long-Term Equity Anticipation Securities): options with expirations past 9 months, out to 3 years, and otherwise identical to standard equity options. When the exam asks which option gives the longest time horizon, LEAPS is the answer.
Index options: settle in cash; exercise an ITM index call and you receive the intrinsic value, no shares delivered. Most are European style, exercisable only at expiration, where standard equity options are American style and exercisable any time before.
Position and exercise limits: the OCC caps the contracts you can hold on one side of the market (position limits) and the contracts you can exercise in any 5 consecutive business days (exercise limits). Both exist to keep manipulation out of the market.
LEAPS (Long-Term Equity Anticipation Securities): options with expirations past 9 months, out to 3 years, and otherwise identical to standard equity options. When the exam asks which option gives the longest time horizon, LEAPS is the answer.
Index options: settle in cash; exercise an ITM index call and you receive the intrinsic value, no shares delivered. Most are European style, exercisable only at expiration, where standard equity options are American style and exercisable any time before.
Position and exercise limits: the OCC caps the contracts you can hold on one side of the market (position limits) and the contracts you can exercise in any 5 consecutive business days (exercise limits). Both exist to keep manipulation out of the market.
Nonequity Options: Index, Yield-Based, and Foreign Currency
Index Options
Index options ride an index value instead of a stock, and settlement is in cash for the in-the-money amount; nothing gets delivered.
- Broad-based: Track the entire market — S&P 100 (OEX), S&P 500 (SPX), Major Market Index (MMI). Used to hedge a diversified portfolio.
- Narrow-based: Track a market segment or sector (technology, biotech, energy). Used for sector-specific hedges.
- VIX: The CBOE Volatility Index measures implied volatility of S&P 500 options. VIX options let investors trade volatility itself — useful when expecting a market shock without a directional view.
Hedging a portfolio with index options: an investor sitting on a diversified portfolio who expects a short-term drop, but does not want to sell, can buy index puts. The market falls, the puts pay; the market rises, the cost was the premium.
Yield-Based (Interest Rate) Options
Yield-based options track Treasury yields, not prices, so everything runs backwards from bond price options:
Yield call profits when
Yields rise (bond prices fall)
Used by investors expecting interest rates to climb — the call goes ITM as the underlying yield index rises above the strike.
Yield put profits when
Yields fall (bond prices rise)
Used by investors expecting interest rates to drop. Yield falling below the strike makes the put ITM.
Foreign Currency Options (FCOs)
FCOs list on six foreign currencies in the U.S.: the Australian dollar, British pound, Canadian dollar, Swiss franc, euro, and Japanese yen. There are no listed options on the U.S. dollar itself, and that absence powers one of the exam's favorite tricks.
Standard contract size
10,000 units
Australian dollar, British pound, Canadian dollar, Swiss franc, Euro, New Zealand dollar.
Japanese yen exception
1,000,000 units
The yen contract is the outlier. Strike prices on yen are also quoted in 1/100 of a cent rather than full cents.
EPIC rule for hedging: U.S.
Exporters buy Puts; Importers
buy Calls.
- An exporter who will receive foreign currency wants to hedge against that currency falling — buy puts on the foreign currency.
- An importer who will pay in foreign currency wants to hedge against that currency rising — buy calls on the foreign currency.
EPIC reverses to IPEC for foreign companies.
Because there are no listed options on the U.S. dollar, a foreign company exporting
to the United States cannot buy USD puts. Instead, it buys calls on its own
currency — because if the dollar weakens, its home currency strengthens, and the
call profits offset the lost USD purchasing power.
Options Taxation: The Three Outcomes
Every options position ends one of exactly three ways: it expires, it gets closed out, or it gets exercised. Each exit has its own tax treatment, and with four basic positions the exam has twelve combinations to draw from; the table holds all of them:
| Position | Option expires | Position closed (sold) | Option exercised |
|---|---|---|---|
| Buy a call | Capital loss equal to premium paid | Capital gain or loss | Strike + premium = stock cost basis |
| Sell a call | Capital gain equal to premium received | Capital gain or loss | Strike + premium = stock sale proceeds |
| Buy a put | Capital loss equal to premium paid | Capital gain or loss | Strike − premium = stock sale proceeds |
| Sell a put | Capital gain equal to premium received | Capital gain or loss | Strike − premium = stock cost basis |
Critical rule: Exercise alone is not a taxable event — it merely establishes the cost basis or proceeds of the resulting stock transaction. The taxable event happens when the underlying stock is later sold.
Married Put
A married put is stock and a protective put bought the same day. The IRS reads them as one hedged position, with a favorable result: a put that expires or gets exercised folds its premium into the stock's cost basis instead of standing as a separate loss, and the stock's holding period stays intact for long-term treatment.
Wash Sale Rule and Options
The wash sale rule disallows a loss when you buy substantially identical securities within 30 days either side of the loss sale, and options complicate "substantially identical" in both directions:
- Selling XYZ stock at a loss and buying XYZ Jan 50 calls within 30 days can trigger a wash sale because calls give the right to acquire the stock.
- Selling XYZ Jan 50 puts at a loss and buying XYZ Jan 55 puts is generally not a wash sale — different series, different securities.
- The wash sale rule applies symmetrically: the disallowed loss is added to the basis of the replacement security and recovered on its eventual sale.
Opening an Options Account: The Approval Workflow
Opening an options account follows its own choreography: four steps, in order, with a 15-day signed-agreement rule the exam never tires of testing.
1
Obtain essential facts from the customer
The registered representative collects investment objectives, employment, estimated income and net worth, marital status, and prior options experience on the new options account form.
2
ROP/branch manager approval, OCC disclosure delivered
A registered options principal (ROP) or qualified branch manager reviews the account and approves the trading levels. The OCC Options Disclosure Document is delivered to the customer at or before this approval.
3
Initial trade may be entered
Once approved, the customer may begin trading. The first trade can occur before the signed agreement is returned, provided approval has been obtained.
4
Customer returns the signed options agreement
The signed agreement must be returned within 15 days of account approval. If it is not returned within that window, the firm may permit only closing transactions until it is.
Memorize the sequence as a four-step
number string: 2-1-4-3. Essential facts (II) come before manager approval (I)
because the manager has nothing to approve without them. The initial trade (IV) can
occur before the signed agreement (III) is returned, but only within the 15-day
window. Some test answers list the actions Roman-numbered — the correct order is
II, I, IV, III.
Contract Adjustments
The OCC adjusts standardized contracts for corporate actions:
- Stock splits (even ratios such as 2:1, 3:1): Number of contracts increases proportionally; strike price decreases proportionally; deliverable shares per contract stays at 100.
- Stock splits (uneven ratios such as 3:2 or 5:4): Number of contracts unchanged; strike price decreases proportionally; deliverable shares per contract increases above 100.
- Cash dividends: No adjustment for ordinary cash dividends. Special or extraordinary cash distributions may trigger an adjustment.
- Stock dividends: Treated like uneven splits — strike adjusts and deliverable shares change.
Concept Check
An American exporter will be paid 25 million Japanese yen when her goods arrive in Japan in 45 days. Which strategy best hedges her foreign exchange risk?
Under the EPIC rule, U.S. Exporters buy Puts; U.S. Importers buy Calls. The exporter is exposed to the yen falling in value before payment — a weaker yen converts to fewer dollars. Long yen puts profit when the yen falls, offsetting the loss on conversion. Buying yen calls is a bullish bet on the yen, not a hedge. Selling yen calls provides only premium-sized protection. Selling yen puts is bullish on the yen and increases the exporter’s exposure. EPIC reverses to IPEC only for foreign companies exporting to the U.S., because no listed options exist on the U.S. dollar.
Concept Check
When a registered representative opens an options account for a new client, in which order must the following actions occur? I. Obtain approval from the registered options principal or branch manager. II. Obtain essential facts from the customer. III. Obtain a signed options agreement from the customer. IV. Enter the initial order.
The required sequence is II, I, IV, III. Essential customer facts must be gathered first because the principal cannot evaluate suitability without them. Manager or ROP approval comes second. The initial trade may be entered after approval. The signed options agreement must be returned within 15 days of account approval — it does not block the first trade, but if it is not returned within the 15-day window, the firm may permit only closing transactions until it is. The other sequences put approval before facts (impossible) or collect the signed agreement before the first trade (not required).
Concept Check
A customer’s options account is approved on March 1. The customer enters two opening trades on March 5 but has not returned the signed options agreement. On March 20, the firm reviews the account. What action is required?
The signed options agreement must be returned within 15 days of account approval. March 20 is 19 days after the March 1 approval, past the deadline. After the deadline, the firm must restrict the account to closing transactions only — the customer can exit existing positions but cannot open new ones until the agreement is received. The firm is not required to liquidate positions, and there is no 30-day grace period. Permitting new trades to continue indefinitely without the signed agreement is a violation that exposes both the firm and the registered representative to disciplinary action.
Summary
Exam Essentials — high-yield review
Chapter Summary
Ch 20 Exam Essentials — Options
- Four basic positions — max gain/loss: Long call: unlimited gain / premium paid. Short call: premium received / unlimited loss. Long put: strike − premium / premium paid. Short put: premium received / strike − premium.
- Breakeven formulas: Long/short call: strike + premium. Long/short put: strike − premium. Long straddle: strike + total premium (upside) and strike − total premium (downside). Short straddle is the opposite.
- Covered call vs. protective put: Covered call (long stock + short call) = neutral/mildly bullish, caps upside, generates income. Protective put (long stock + long put) = bullish but hedged, floors the downside.
- Spreads — debit vs. credit: Bull call spread = buy lower call, sell higher call = net debit = moderately bullish. Bear put spread = buy higher put, sell lower put = net debit = moderately bearish. Credit spreads are the mirror positions.
- Index options: Cash-settled (no physical delivery of shares). Most are European-style (exercise at expiration only). Equity options are American-style (exercise any time before expiration). LEAPS = options with >9 months to expiration.
Options Exam Traps — Consolidated
The Series 7 returns to a small set of recurring distinctions in this content area. If a question feels familiar, it is probably one of these:
1. PIT identity. Premium = Intrinsic + Time. Trading at parity means the option’s premium equals its intrinsic value (no time value), typically near expiration. The original purchase price is irrelevant to the parity determination.
2. Naked call sellers face unlimited loss. Of the four basic positions, only the short uncovered call has unlimited loss potential. Long calls and long puts cap loss at the premium paid; short uncovered puts cap loss at strike minus premium.
3. Debit = widen = exercise (DWE) for spread questions. Debit spreads profit if the difference between the premiums widens or if the long option is exercised. Credit spreads profit if the spread narrows or both options expire worthless.
4. Hedge always pairs opposite sentiment. Long stock pairs with bearish options (long put, short call). Short stock pairs with bullish options (long call, short put). The position and the option must offset.
5. Covered put = short stock + short put, not cash + short put. The short stock provides the cash to satisfy the put if assigned. Cash-secured puts are a different concept and not what "covered" refers to here.
6. Equity options now settle T+1, not T+2. Both premium settlement and exercise (stock delivery) follow the SEC T+1 rule effective May 28, 2024. Older study materials still saying T+2 are out of date.
7. Index option exercise settles cash, next business day. No stock is delivered — the writer pays the holder the in-the-money amount.
8. Yield-based options behave opposite to bond options. Yield calls profit when interest rates rise (bond prices fall); yield puts profit when interest rates fall.
9. Yen FCO is the contract-size outlier: 1,000,000 units. All other listed FCOs are 10,000 units. Yen strike prices are quoted in 1/100 of a cent.
10. EPIC for U.S. companies; IPEC reverses for foreign companies. U.S. exporters buy puts on the foreign currency; U.S. importers buy calls. Foreign companies exporting to the U.S. buy calls on their own currency.
11. Options account opening sequence: II, I, IV, III. Essential facts → manager approval → initial trade → signed agreement returned. The signed agreement deadline is 15 days from approval; after that, closing transactions only.
12. Exercise alone is not a taxable event. Exercising an option establishes cost basis or proceeds for the resulting stock transaction. The capital gain or loss is recognized when the stock itself is later sold.
13. Distractor terms to ignore. Butterfly, condor, iron butterfly, iron condor, strangle. The Series 7 will sometimes list these in the answer choices to a basic strategy question — they almost always belong in the wrong-answer pile on this exam.
The Series 7 returns to a small set of recurring distinctions in this content area. If a question feels familiar, it is probably one of these:
1. PIT identity. Premium = Intrinsic + Time. Trading at parity means the option’s premium equals its intrinsic value (no time value), typically near expiration. The original purchase price is irrelevant to the parity determination.
2. Naked call sellers face unlimited loss. Of the four basic positions, only the short uncovered call has unlimited loss potential. Long calls and long puts cap loss at the premium paid; short uncovered puts cap loss at strike minus premium.
3. Debit = widen = exercise (DWE) for spread questions. Debit spreads profit if the difference between the premiums widens or if the long option is exercised. Credit spreads profit if the spread narrows or both options expire worthless.
4. Hedge always pairs opposite sentiment. Long stock pairs with bearish options (long put, short call). Short stock pairs with bullish options (long call, short put). The position and the option must offset.
5. Covered put = short stock + short put, not cash + short put. The short stock provides the cash to satisfy the put if assigned. Cash-secured puts are a different concept and not what "covered" refers to here.
6. Equity options now settle T+1, not T+2. Both premium settlement and exercise (stock delivery) follow the SEC T+1 rule effective May 28, 2024. Older study materials still saying T+2 are out of date.
7. Index option exercise settles cash, next business day. No stock is delivered — the writer pays the holder the in-the-money amount.
8. Yield-based options behave opposite to bond options. Yield calls profit when interest rates rise (bond prices fall); yield puts profit when interest rates fall.
9. Yen FCO is the contract-size outlier: 1,000,000 units. All other listed FCOs are 10,000 units. Yen strike prices are quoted in 1/100 of a cent.
10. EPIC for U.S. companies; IPEC reverses for foreign companies. U.S. exporters buy puts on the foreign currency; U.S. importers buy calls. Foreign companies exporting to the U.S. buy calls on their own currency.
11. Options account opening sequence: II, I, IV, III. Essential facts → manager approval → initial trade → signed agreement returned. The signed agreement deadline is 15 days from approval; after that, closing transactions only.
12. Exercise alone is not a taxable event. Exercising an option establishes cost basis or proceeds for the resulting stock transaction. The capital gain or loss is recognized when the stock itself is later sold.
13. Distractor terms to ignore. Butterfly, condor, iron butterfly, iron condor, strangle. The Series 7 will sometimes list these in the answer choices to a basic strategy question — they almost always belong in the wrong-answer pile on this exam.
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Practice Questions
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