Options Strategies: Mastering the SIE Exam

3.4.2 Options Strategies

Options strategies are an essential component of the securities industry, offering investors a range of tools for speculation, income generation, and risk management. Understanding these strategies is crucial for anyone preparing for the Securities Industry Essentials (SIE) Exam. This section will guide you through the basic and advanced options strategies, their objectives, risks, and regulatory considerations.

Basic Options Strategies

Options are financial derivatives that provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified expiration date. The basic strategies involve buying or selling call and put options.

Long Call

Objective: The primary goal of a long call strategy is to profit from an anticipated increase in the price of the underlying asset. By purchasing a call option, you gain the right to buy the asset at the strike price within a specified period.

• Risk: The risk is limited to the premium paid for the option. If the asset’s price does not rise above the strike price by expiration, the option will expire worthless, and you lose the premium.
• Reward: The potential reward is theoretically unlimited as the asset’s price can rise indefinitely. The profit is the difference between the asset’s price and the strike price, minus the premium paid.

Example: Suppose you purchase a call option for Company XYZ with a strike price of $50, paying a premium of $2 per share. If the stock price rises to $60, you can exercise the option to buy at $50, resulting in a profit of $8 per share ($60 - $50 - $2).

Long Put

Objective: A long put strategy aims to profit from a decline in the underlying asset’s price. By buying a put option, you acquire the right to sell the asset at the strike price.

• Risk: The risk is limited to the premium paid. If the asset’s price remains above the strike price, the option expires worthless.
• Reward: The reward is limited to the strike price minus the premium if the asset’s price falls to zero.

Example: You buy a put option for Company ABC with a strike price of $40, paying a $3 premium. If the stock price drops to $30, you can sell at $40, making a profit of $7 per share ($40 - $30 - $3).

Short Call

Objective: Selling a call option, or a short call, aims to generate income through the premium received, expecting the asset’s price to remain below the strike price.

• Risk: The risk is potentially unlimited if the asset’s price rises significantly, as you may be obligated to sell the asset at the strike price.
• Reward: The reward is limited to the premium received.

Example: You sell a call option on Stock DEF with a strike price of $100, receiving a $5 premium. If the stock remains below $100, you keep the premium. However, if the stock rises to $110, you incur a loss of $5 per share ($110 - $100 - $5).

Short Put

Objective: A short put strategy involves selling a put option to generate income, expecting the asset’s price to remain above the strike price.

• Risk: The risk is significant if the asset’s price falls sharply, as you may be obligated to buy the asset at the strike price.
• Reward: The reward is limited to the premium received.

Example: You sell a put option on Stock GHI with a strike price of $30, receiving a $2 premium. If the stock remains above $30, you keep the premium. If the stock falls to $25, you incur a loss of $3 per share ($30 - $25 - $2).

Advanced Options Strategies

Advanced options strategies involve combinations of buying and selling options to achieve specific objectives, such as hedging risk or profiting from volatility.

Protective Put

A protective put involves buying a put option to hedge against potential losses in an owned asset. This strategy is akin to purchasing insurance for your investment.

• Objective: Protect against downside risk while maintaining upside potential.
• Risk: Limited to the premium paid for the put.
• Reward: Unlimited if the asset’s price rises, minus the cost of the put.

Example: You own shares of Company JKL, currently trading at $50. To protect against a decline, you buy a put option with a strike price of $45, paying a $3 premium. If the stock falls to $40, you can sell at $45, limiting your loss to $8 per share ($50 - $45 + $3).

Covered Call

A covered call involves writing a call option against owned shares to generate income with limited risk.

• Objective: Generate additional income from owned shares.
• Risk: Limited to the loss of potential upside if the stock rises above the strike price.
• Reward: Limited to the premium received plus any stock appreciation up to the strike price.

Example: You own shares of Company MNO, trading at $60, and sell a call option with a strike price of $65, receiving a $2 premium. If the stock remains below $65, you keep the premium. If it rises above $65, you must sell at $65, capping your profit.

Straddle

A straddle involves buying or selling both a call and a put option of the same strike price and expiration to profit from volatility or lack thereof.

• Objective: Profit from significant price movement in either direction.
• Risk: For a long straddle, the risk is limited to the total premiums paid. For a short straddle, the risk is unlimited.
• Reward: Unlimited for a long straddle if the asset moves significantly.

Example: You buy a call and a put option on Stock PQR, each with a strike price of $50, paying $3 per option. If the stock moves to $60 or $40, you profit from the movement, offsetting the cost of the options.

Spread Strategies

Spread strategies involve multiple options positions to limit risk or speculate on price movements.

• Vertical Spread: Involves buying and selling options of the same type (calls or puts) with different strike prices.
  • Example: A bull call spread involves buying a call with a lower strike price and selling a call with a higher strike price.
• Horizontal (Calendar) Spread: Involves buying and selling options of the same type and strike price but different expirations.
  • Example: Buying a longer-term call and selling a shorter-term call at the same strike price.
• Diagonal Spread: Combines elements of vertical and horizontal spreads, using options of different strike prices and expirations.

Benefits of Options Strategies

Options strategies offer various benefits, including:

• Income Generation: Collecting premiums through option writing can provide a steady income stream.
• Risk Management: Hedging positions to limit potential losses is a key advantage of options.
• Speculation: Options allow investors to leverage their market views on asset price movements with limited capital.

Risks of Options Strategies

Despite their benefits, options strategies carry significant risks:

• Complexity: Advanced strategies require a thorough understanding of options mechanics and market conditions.
• Risk of Losses: Potential for significant losses, especially with uncovered (naked) option writing.
• Transaction Costs: Multiple positions may increase fees and commissions, impacting profitability.
• Assignment Risk: Obligation to fulfill the contract if assigned, which can lead to unexpected losses.

Regulatory Considerations

Options trading is subject to stringent regulatory oversight to protect investors:

• Suitability Requirements: Brokers must ensure clients understand the risks and strategies involved in options trading.
• Option Agreement Form: Clients must sign an agreement before trading options, acknowledging their understanding of the risks.
• Margin Requirements: Certain strategies, especially those involving short positions, may require margin accounts to cover potential obligations.

Options Strategies and the SIE Exam

For the SIE Exam, it is crucial to understand both basic and advanced options strategies, their objectives, benefits, and risks. Familiarity with options terminology and the construction of different strategies is essential. Additionally, recognizing regulatory considerations and investor suitability is a key component of the exam.

Glossary

• Protective Put: Buying a put option to hedge against a decline in the value of a long stock position.
• Covered Call: Selling a call option while owning the underlying stock.
• Straddle: An options strategy involving the purchase or sale of both a call and a put option with the same strike price and expiration date.
• Spread: An options strategy involving multiple positions to limit risk or speculate on price movements.

References

• OCC’s Options Strategies: Basic Options Strategies
• FINRA’s Investor Alerts: Options Trading

SIE Exam Practice Questions: Options Strategies