Series 7 Exam 2022-2023 For Dummies with Online Practice Tests by Steven M. Rice

Author:Steven M. Rice [Rice, Steven M.]
Language: eng
Format: epub
ISBN: 9781119796855
Publisher: Wiley
Published: 2021-05-06T00:00:00+00:00

You see more Money In at this point than Money Out, so you have a maximum gain, not a maximum loss; therefore, you have to exercise the option to get the answer you need. Make sure you exercise the option at the strike price. The strike price is 30, so enter $3,000 under its premium. (Remember calls same: The premium and multiplied strike price go on the same side of the chart.) Total up the two sides, and you see that the maximum potential loss for Mr. Bullwork is $800 ($3,300 – $2,500).

Remember that an investor who is long a particular security can buy an option on that same security to protect the position in the event that the price of the security declines or can sell an option on that same security to bring in money. For example, if an investor who is long 100 shares of DEF at 52 decides to sell a 55 call option at 4 on DEF (covered call) to bring some additional money (the $4 per share premium) into their account. The good part is that they lowered their break-even point to $48 ($52 per share for the stock minus $4 per share for the premium). The bad part is that they limited their upside potential for the remaining time on the option contract to $55 per share because they sold the right to have someone purchase the stock from them at $55. If this investor purchased a 50 put option at 2 (protective put) to limit their downside if the price of DEF starts to decrease, they just increased their break-even point from $52 to $54 ($52 per share for the stock plus $2 per share for the option).

The opposite holds true for investors who sold short. An investor who is short a particular security can purchase a call to protect themselves in the event that the price of the security increases and can also sell a put on security shorted to bring some additional money into their account.

Investors who are long a stock may decide to sell a covered call on the underlying stock and purchase a protective put on the same underlying stock. This is known as a collar. If the cost of the premiums are equal, it is considered a cashless collar. Even though the cost of the trades may offset each other and now the investor has limited their downside risk, they had also limited their upside potential.

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