Most advanced option questions are arithmetic once you can name the position. Work out which legs were bought or sold, whether money went out or came in, and which way the market has to move. Once you know that, the answer choices sort themselves.
Every strategy in this lesson is built from four single positions. Figures are per share. Multiply by 100 for one standard contract, then by the number of contracts.
Single-option math (maximum gain, maximum loss and breakeven for long and short calls and puts) rests on two habits. A call breaks even above its strike, at the strike plus the premium. A put breaks even below its strike, at the strike minus the premium. The buyer and the writer share one breakeven, because every dollar one side gains, the other side loses.
- Long call: The most you can lose is the premium. Gains above the breakeven are unlimited.
- Short call: The most you can gain is the premium. Losses are unlimited if the stock keeps rising.
Common mistakes
- Using 15% for every index: Only broad-based index options use 15%. A narrow-based (industry) index option uses 20%, which turns the $28,000 index call requirement into $38,000.
- Basing the put minimum on market value: The put floor is 10% of the aggregate exercise price. In Example 2, the 40 put's floor is $450, not $50 + $500 = $550.
- Calling every bull spread a debit: A bull put spread is a credit. Label a spread by its expensive leg, not by whether it's bull or bear.
Bottom line
- Calls break even at strike plus premium and puts at strike minus premium.
- A spread buys and sells the same type; buying the costlier leg makes it a debit spread, selling it a credit spread.
- A debit spread risks the net debit and can gain the strike difference minus the debit; a credit spread is the reverse.
- A straddle uses one strike and expiration; a combination differs in strike, expiration or both.
Exam shortcut
Work every multi-leg question in the same order. First, write each leg as a buy or a sell. Next, net the premiums: whoever paid the larger premium is on the debit side. Then read direction from the strikes: if the customer bought the lower strike, the position is bullish. Breakeven follows the option type. For calls, add the net premium to the lower strike.
The full lesson (about 5,047 words, 34 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C19
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