Options Strategies

Covered Calls

A covered call is the most conservative and commonly tested options strategy on the Series 7 exam. It involves owning 100 shares of the underlying stock and writing (selling) one call option against those shares. The long stock position "covers" the obligation created by the short call, meaning if the buyer exercises, the writer can simply deliver the shares they already own.

Why Write Covered Calls?

The primary motivation for writing covered calls is to generate income from the premium received. Investors who are moderately bullish or neutral on a stock they own can collect premium income while waiting for the stock to appreciate. This strategy is commonly used by income-oriented investors and portfolio managers.

Profit, Loss, and Breakeven

• Market outlook: Neutral to moderately bullish
• Maximum gain: Premium received + (Strike price - Stock purchase price) x 100. The stock can only appreciate to the strike price before being called away.
• Maximum loss: (Stock purchase price - Premium received) x 100. The stock could fall to zero, but the premium offsets some of the loss.
• Breakeven: Stock purchase price - Premium received

Protective Puts

A protective put (also called a "married put") involves buying a put option while owning the underlying stock. Think of it as buying insurance on a stock position. The put guarantees a minimum selling price (the strike price), limiting downside risk while preserving unlimited upside potential.

Profit, Loss, and Breakeven

• Market outlook: Bullish (investor wants to keep the stock but fears a short-term decline)
• Maximum gain: Unlimited (if the stock rises, the put expires worthless and the stock appreciates; gain is reduced by the premium paid for the put)
• Maximum loss: (Stock purchase price - Strike price + Premium paid) x 100. The put limits how much the stock loss can be.
• Breakeven: Stock purchase price + Premium paid

Collars

A collar combines a covered call with a protective put. The investor owns 100 shares of stock, writes an out-of-the-money call, and buys an out-of-the-money put. The premium received from the call offsets (partially or entirely) the cost of the put. A "zero-cost collar" occurs when the call premium exactly equals the put premium.

How It Works

• The put sets a floor (minimum selling price) for the stock
• The call sets a ceiling (maximum selling price) for the stock
• The investor's profit and loss are both limited within a defined range

Spread Strategies

A spread involves simultaneously buying and selling options of the same type (both calls or both puts) on the same underlying stock, but with different strike prices and/or expiration dates. Spreads limit both maximum gain and maximum loss. There are two main categories: vertical spreads (different strikes, same expiration) and horizontal/calendar spreads (same strike, different expirations). The Series 7 focuses primarily on vertical spreads.

Debit Spreads vs. Credit Spreads

Understanding whether a spread is a debit or credit is essential:

• Debit spread: The option purchased costs more than the option sold. The investor pays a net premium (net debit). Maximum loss = net debit paid. Maximum gain = difference in strikes - net debit.
• Credit spread: The option sold generates more premium than the option purchased costs. The investor receives a net premium (net credit). Maximum gain = net credit received. Maximum loss = difference in strikes - net credit.

Bull Call Spread (Debit Call Spread)

A bull call spread involves buying a call with a lower strike price and selling a call with a higher strike price (same expiration). This is a moderately bullish strategy that costs a net debit.

• Construction: Buy lower strike call + Sell higher strike call
• Market outlook: Moderately bullish
• Max gain: Difference in strikes - Net debit
• Max loss: Net debit paid
• Breakeven: Lower strike + Net debit

Bear Put Spread (Debit Put Spread)

A bear put spread involves buying a put with a higher strike price and selling a put with a lower strike price (same expiration). This is a moderately bearish strategy that costs a net debit.

• Construction: Buy higher strike put + Sell lower strike put
• Market outlook: Moderately bearish
• Max gain: Difference in strikes - Net debit
• Max loss: Net debit paid
• Breakeven: Higher strike - Net debit

Bull Put Spread (Credit Put Spread)

A bull put spread involves selling a put with a higher strike price and buying a put with a lower strike price. This is a moderately bullish strategy that generates a net credit. The investor wants the stock to stay above the higher strike so both puts expire worthless.

• Construction: Sell higher strike put + Buy lower strike put
• Market outlook: Moderately bullish
• Max gain: Net credit received
• Max loss: Difference in strikes - Net credit
• Breakeven: Higher strike - Net credit

Bear Call Spread (Credit Call Spread)

A bear call spread involves selling a call with a lower strike price and buying a call with a higher strike price. This is a moderately bearish strategy that generates a net credit. The investor wants the stock to stay below the lower strike so both calls expire worthless.

• Construction: Sell lower strike call + Buy higher strike call
• Market outlook: Moderately bearish
• Max gain: Net credit received
• Max loss: Difference in strikes - Net credit
• Breakeven: Lower strike + Net credit

Straddles and Combinations

Straddles and combinations involve buying or selling both a call AND a put on the same underlying stock. These strategies are used when an investor has a view on volatility rather than direction.

Long Straddle

A long straddle involves buying a call AND buying a put with the same strike price and expiration date. The investor expects a large price move in either direction but is unsure which way.

• Construction: Buy 1 call + Buy 1 put (same strike and expiration)
• Market outlook: Volatile (expects a big move up OR down)
• Max gain: Unlimited on the upside; substantial on the downside (strike - combined premiums, if stock drops to $0)
• Max loss: Total premiums paid (both call and put premiums). This occurs if the stock is exactly at the strike price at expiration.
• Breakeven (upper): Strike + Total premiums
• Breakeven (lower): Strike - Total premiums

Short Straddle

A short straddle involves writing a call AND writing a put with the same strike price and expiration date. The investor expects the stock to remain stable near the strike price, allowing both options to expire worthless and keeping both premiums.

• Construction: Write 1 call + Write 1 put (same strike and expiration)
• Market outlook: Neutral / Stable (expects little price movement)
• Max gain: Total premiums received. This occurs if the stock is exactly at the strike price at expiration.
• Max loss: Unlimited on the upside (due to the short call); substantial on the downside (stock can fall to $0)
• Breakeven (upper): Strike + Total premiums
• Breakeven (lower): Strike - Total premiums

Combinations

A combination is similar to a straddle but uses different strike prices, different expiration dates, or both. For example, buying a call with a $55 strike and buying a put with a $45 strike (same expiration) is a long combination (sometimes called a long strangle). Combinations are cheaper than straddles because one or both options are further out-of-the-money, but the stock must move further to reach profitability.

• Long strangle: Buy OTM call + Buy OTM put. Cheaper than a straddle but requires a larger move to profit. Two breakeven points.
• Short strangle: Sell OTM call + Sell OTM put. Collects less premium than a short straddle but has a wider profitable range.

Strategy Comparison Table

The following table summarizes the key characteristics of the most important options strategies tested on the Series 7.

Margin Requirements Overview

Options trading requires different levels of margin depending on the risk involved. The Series 7 tests a general understanding of margin requirements for options, not exact calculations.

• Long options (buying calls or puts): Must be paid for in full. No margin allowed for purchasing options. The buyer must pay 100% of the premium.
• Covered call writing: No additional margin required beyond owning the underlying stock, because the stock covers the obligation.
• Naked (uncovered) call writing: Requires the most margin due to unlimited risk. Margin = 100% of premium + 20% of underlying stock value - any amount out-of-the-money (minimum 10% of stock value + premium).
• Naked put writing: Similar margin formula to naked calls, but the minimum is 10% of the strike price + premium.
• Spreads: Debit spreads must be paid for in full. Credit spreads require margin equal to the difference in strike prices minus the net credit received.