Options strategies range from simple single-leg positions to complex multi-leg combinations. The Series 7 exam tests your ability to identify the correct strategy for a given market outlook, calculate maximum gain/loss/breakeven, and understand why each strategy is used. This section covers the most frequently tested strategies.
A useful framework for every strategy: before solving, identify (1) the market outlook and (2) whether it's debit or credit.
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The investor buys a call option, paying the premium. Profits if the stock rises significantly above the strike.
> Example: Buy 1 XYZ $50 call at $3. Breakeven = $53. If stock goes to $65, gain = $65 − $53 = $12 per share.
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The investor buys a put option, paying the premium. Profits if the stock falls significantly below the strike.
> Example: Buy 1 XYZ $50 put at $3. Breakeven = $47. If stock falls to $35, gain = $47 − $35 = $12 per share.
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The investor owns the underlying stock and writes (sells) a call against it. The premium received is income. The "covered" part means the short call is protected because the investor can deliver shares they already own.
> Example: Own 100 shares of XYZ at $48. Sell 1 $50 call for $3 premium. > - Max gain = ($50 − $48) + $3 = $5 per share = $500 > - Breakeven = $48 − $3 = $45 (protected to $45 on the downside) > - Max loss = $45 (stock goes to zero, keeping the $3 premium) > > Why use it: Generates income on shares you plan to hold. Trade-off: you cap your upside at the strike price. If the stock shoots to $70, you still only get $50 (you sold the upside).
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The investor owns the underlying stock and buys a put to protect against downside. Acts like insurance.
> Example: Own 100 shares at $48. Buy 1 $45 put for $2. > - Max loss = ($48 − $45) + $2 = $5 per share = $500 (no matter how far stock falls, you can put at $45) > - Breakeven = $48 + $2 = $50 (stock must rise to $50 to recover the premium cost) > > Why use it: Classic portfolio insurance. A pension fund owning a large stock position buys puts before an earnings report to limit downside while keeping upside potential.
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Spreads involve buying one option and selling another of the same type (both calls or both puts) on the same underlying, with different strikes or expirations. Spreads reduce risk AND reduce potential profit.
Buy a lower-strike call, sell a higher-strike call. Both same expiration. Net debit.
> Example: Buy $50 call at $5, sell $55 call at $2. Net debit = $3. > - Max gain = ($55 − $50) − $3 = $2 > - Max loss = $3 (net premium paid) > - Breakeven = $50 + $3 = $53
Why use it instead of a simple long call: Lower net cost (the sold call offsets part of the premium), but the tradeoff is capped upside.
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Buy a higher-strike put, sell a lower-strike put. Both same expiration. Net debit.
> Example: Buy $55 put at $5, sell $50 put at $2. Net debit = $3. > - Max gain = ($55 − $50) − $3 = $2 > - Max loss = $3 > - Breakeven = $55 − $3 = $52
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A straddle involves buying (or selling) a call AND a put with the same strike price and same expiration on the same underlying.
Buy both a call and a put at the same strike. Pay two premiums.
> Example: Stock at $50. Buy $50 call at $4 and $50 put at $3. Total premium = $7. > - Upper breakeven = $50 + $7 = $57 > - Lower breakeven = $50 − $7 = $43 > - Max loss = $7 (stock closes exactly at $50 — both options expire worthless) > - Profit if stock goes to $62: Call value = $12 − $7 cost = $5 profit
When used: Before major announcements (earnings, FDA decisions, mergers) when the investor expects a large move but doesn't know which way.
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Sell both a call and a put at the same strike. Collect two premiums.
Why use it: Market makers and volatility traders sell straddles when they believe options are overpriced (implied volatility is too high). They profit from time decay as long as the stock stays range-bound.
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| Strategy | Position | Outlook | Cost | Max Gain | Max Loss | Breakeven | |---|---|---|---|---|---|---| | Long Call | Buy call | Bullish | Debit | Unlimited | Premium | Strike + Premium | | Short Call | Sell call | Neutral/Bearish | Credit | Premium | Unlimited | Strike + Premium | | Long Put | Buy put | Bearish | Debit | Strike − Premium | Premium | Strike − Premium | | Short Put | Sell put | Neutral/Bullish | Credit | Premium | Strike − Premium | Strike − Premium | | Covered Call | Own stock + sell call | Neutral/Income | Credit (net) | (Strike − Cost) + Premium | Cost − Premium | Cost − Premium | | Protective Put | Own stock + buy put | Insurance | Debit | Unlimited | (Cost − Strike) + Premium | Cost + Premium | | Bull Call Spread | Buy low call + sell high call | Mod. Bullish | Net Debit | Strike diff − Net premium | Net premium | Low strike + Net premium | | Bear Put Spread | Buy high put + sell low put | Mod. Bearish | Net Debit | Strike diff − Net premium | Net premium | High strike − Net premium | | Long Straddle | Buy call + buy put (same strike) | Big move expected | Debit | Unlimited / Strike − Premium | Total premium | Strike ± Total premium | | Short Straddle | Sell call + sell put (same strike) | No move expected | Credit | Total premium | Unlimited | Strike ± Total premium |
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Quiz Questions:
Q1. An investor buys 1 ABC $45 call for $3 and sells 1 ABC $50 call for $1. The net premium paid is $2. What is the maximum gain on this position?
A) $2 B) $3 C) $5 D) $8
Answer: B — This is a bull call spread. Max gain = Difference in strikes − Net premium = ($50 − $45) − $2 = $3. The maximum gain is realized when the stock is at or above the higher strike ($50) at expiration. Net premium ($2) is the max loss, not the max gain (A). $5 is the strike spread before subtracting the net premium (C). $8 would result from incorrect addition (D).
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Q2. An investor who owns 500 shares of XYZ at $52 sells 5 XYZ $55 calls for $2 each. Which of the following BEST describes this strategy and its primary purpose?
A) Long straddle — to profit from a large price move in either direction B) Protective put — to hedge downside risk in the stock position C) Covered call — to generate premium income while capping upside D) Bull call spread — to profit from a moderate rise in the stock
Answer: C — Owning stock and selling calls against it is a covered call strategy. The investor generates $2/share ($1,000 total) in premium income. The trade-off is that upside is capped at $55 — if the stock rises above $55, shares get called away. A long straddle involves buying both calls and puts (A). A protective put involves buying puts, not selling calls (B). A bull call spread involves buying one call and selling another without an underlying stock position (D).
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Q3. A long straddle is purchased on MNO stock (currently at $60): 1 $60 call at $5 and 1 $60 put at $4. What are the breakeven points?
A) $65 and $55 B) $69 and $51 C) $65 and $51 D) $69 and $55
Answer: B — Total premium = $5 + $4 = $9. Upper breakeven = $60 + $9 = $69. Lower breakeven = $60 − $9 = $51. The investor needs the stock to move more than $9 in either direction to profit. Adding only the call premium to get $65 or subtracting only the put premium to get $56 are common errors — always add TOTAL premium for straddle breakevens (A, C, D all make this error).
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Q4. An investor buys 1 DEF $70 put for $6 as a protective put while holding 100 shares purchased at $72. What is the maximum loss on the combined position?
A) $6 B) $8 C) $2 D) $72
Answer: B — With a protective put, the investor's downside is floored at the strike price. Max loss = (Stock Purchase Price − Strike Price) + Premium = ($72 − $70) + $6 = $8 per share. No matter how low the stock falls, the investor can put (sell) at $70, losing at most $2 on the stock, plus the $6 premium paid. The premium alone (A) ignores the stock loss below cost. The "in-the-money amount" alone (C = $72 − $70) ignores the premium cost. The full stock price would only be the loss if no put existed (D).
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Q5. Which of the following strategies has UNLIMITED maximum loss potential?
A) Long straddle B) Covered call C) Short straddle D) Protective put
Answer: C — A short straddle involves selling both a call and a put. The short call leg has unlimited loss potential (the stock can rise indefinitely), making the overall position's maximum loss unlimited. A long straddle's maximum loss is capped at the total premium paid (A). A covered call's maximum loss is limited to stock going to zero minus the premium received (B). A protective put's maximum loss is capped by the put floor minus premium (D).