Updated July 6, 2022

Options are a frequently tested topic on the **FINRA Series 7 exam**. While there are some difficult options questions that involve calculations and identifying different types of spreads, there are also several basic-type options questions. Remembering a few essential points will help you get these more basic questions correct on the exam. Let’s go through some options basics that could be tested on the Series 7 exam.

### Good to Know Definitions:

**Options Contract:** A contract that allows the holder to buy or sell 100 shares of an underlying security at a given price by a given date.

**Underlying (security)** = refers to the security that must be delivered when an options contract is exercised

**Expiration Date: **The last day an options contract may be freely exercised before it becomes void. The last day is always the third Friday of the month.

**Exercise or Strike Price:** The price at which an options holder may buy or sell an underlying security.

**Premium:** The price paid to an option writer for the right to exercise the option before it expires.

**Breakeven Point:** The market price of an underlying stock at which the investor neither makes nor loses money

## Premiums and Maximum Potential Gain and Maximum Potential Loss

One options topic that comes up often is maximum potential gain and maximum potential loss for different types of options. A concept related to maximum gain and maximum loss that’s easy to remember is that the premium *received* is the maximum potential *gain* for an option seller, while the premium *paid* is the maximum potential *loss* for an option buyer.

Why is that? Remember that when an investor opens a position by shorting an option, he takes in the premium from the sale. The best-case scenario for that investor is that the option expires unexercised. If that occurs, the investor doesn’t need to take any further action related to the option; he keeps the premium and doesn’t have to shell out money to anyone else.

### Example:

If Tim shorts an ABC call option and receives $500 in premiums, his maximum potential gain is $500. He will achieve this gain if the option expires unexercised. In that case, he simply gets to keep the $500 he received when he shorted the option. The same is true for an investor who shorts a put option: he takes in the premium when the option is sold, and if the option expires unexercised, he gets to keep the premium.

On the other hand, an options buyer’s maximum potential loss is the premium paid, or the cost of the option. An option buyer pays the premium to the option seller to open her long options position. If she holds the option through expiration and it’s never exercised, she won’t receive any money from her option transaction. That means the premium paid represents sunk cost or loss on the investment.

### Example:

If Sally purchases an XYZ put option and pays a premium of $600, her maximum potential loss is $600. She’ll realize this loss if the option expires unexercised and she holds it through expiration.

## In the Money

Another topic that shows up on the Series 7 exam related to options is whether the option is “in the money.” When it comes to these questions, remember that an option is “in the money” when it’s advantageous for its owner to exercise the option. That means a **call option** is in the money when its underlying security is trading at a price that *exceeds* the option’s strike price. In that case, the option holder can exercise the option by purchasing the underlying at the strike price and then selling it at its higher market price.

On the other hand, a **put option** is in the money when its underlying security is trading at a price *below* the strike price. In that case, the option holder can purchase the underlying security at the market price and then sell it to the option seller assigned the exercised option at the higher strike price.

Note that the phrase “in the money” applies to a call option whose underlying is above the strike price and a put option whose underlying is below the strike price, even if the question is talking about a short options investor’s investment. That’s because the phrase “in the money” is a FINRA definition that applies to the option itself and not a particular position taken related to the option.

## Breakeven Points

Breakeven points are another basic topic you should understand for the exam. The **breakeven point** is the amount that the underlying security needs to be trading at for both buyer and seller to break even on the investment when the option is exercised.

### Example:

If Bobby is long a WTC call option with a $50 strike price and a $5 premium, his breakeven point would be $55 ($50 strike price + $5 premium). This means that when WTC is trading at $55, he could exercise his option by purchasing the underlying shares at $50. He could then sell those shares at the market price of $55. He would net $5 from his purchase and sale. However, since he paid $5 in premiums to buy the option, his $5 gain would be washed out by that $5 payment. Hence, he would breakeven on his investment.

The breakeven point for a put option is the option’s strike price minus its premium. If the underlying is trading at that value and the options holder exercises the option, both buyer and seller would breakeven on their investments.

### Example:

If Jane is long an XYZ put option with a strike price of $40 and a premium of $4, her breakeven point would be $36 ($40 strike price – $4 premium). This means than when XYZ is trading at $36, she can purchase the underlying shares at that value and then exercise the option by selling them to the seller assigned her option for the $40 strike price. She would net $4 from her purchase and sale. However, since she paid $4 in premiums to buy the option, her $4 gain would be washed out by that $4 payment. Hence, she would breakeven on her investment.

## Trading Options

An investor can exit his options position in one of two ways: he can **exercise the option** or he can **trade the option**.

**Exercising the option** involves either buying underlying shares at the strike price in a call option or selling the underlying shares at the strike price in a put option.

**Trading an option** involves taking the opposite position to an open position, thereby closing that open position. That means that someone who is long a call option can trade his option by shorting the same call, while an investor who is long a put option can trade his option by shorting the same put. Investors who have an open short options position (i.e., they shorted the option and it has yet to expire) can close out their position by purchasing the same option.

When an investor trades an option, gain or loss is calculated by subtracting the premium paid when going long the option from the premium received when shorting the option. If the difference is positive, the investor has a gain. If the difference is negative, the investor has a loss.

### Example:

If Marie is long an END call option for which she paid $1,000 total in premiums and she decides to close out her position by shorting the same option, receiving $1,200 in premiums, she will realize a $200 gain ($1,200 received – $1,000 paid). Once she closes her position, she has no other obligation regarding the option because her short position is entered to close out a previous long position.

Note that traded options settle on the business day after the trade date.

## Options Premiums

Knowing a bit about options premiums is also important for the Series 7 exam. Remember the **premium** is the amount an investor pays to go long an option or receives when shorting an option. An option’s premium is essentially its market price.

The premium is made up of two components: intrinsic value and time value. A premium’s **intrinsic value** is the amount by which the option is in the money. So for a call option, the intrinsic value is the amount that the underlying security’s price is above the strike price.

For a put option, the intrinsic value is the amount that the underlying security’s price is below the strike price. For instance, the premium for a put option with a strike price of $20 and an underlying security trading at $17 would have $3 in intrinsic value.

It’s also important to note that an option premium’s intrinsic value can never be a negative number. If the option is out of the money, its intrinsic value will be 0. So, for instance, if an ABC call option has a strike price of 50 and ABC is trading at 45, the option premium’s intrinsic value would be 0; it would not be -5.

A premium’s **time value** is the difference between its total amount and the intrinsic value. So t**ime value = premium – intrinsic value**. That means an option with a premium of $10 that is in the money by $6 will have a time value of $4 ($10 premium – $6 intrinsic value = $4 time value). Time value typically decreases the closer an option is to its expiration date.

## American vs. European Options

Options can be either American-style or European-style. Equity options are American-style options. This means they can be executed at any point prior to or on their expiration date. The expiration date for monthly equity options is the third Friday of the month in which the option expires.

Non-equity options, such as index options, are often European-style options. This means they can only be executed on the expiration date. It is important to remember, however, that either European- or American-style options can be traded on the secondary market at any time before expiration.

If you keep these basics in mind, you should be able to answer many of the options questions that show up on the Series 7 exam correctly. Understanding the points described above will also help you have a better understanding of some of the concepts tested by the more difficult options questions that appear on the exam.

If you’re preparing for the Series 7 exam, explore **Solomon Exam Prep Series 7 study materials**. Solomon offers a Series 7 Study Guide, Exam Simulator, Video Lecture, Audiobook, Flashcards, and Live Web Classes to help you pass.