General Securities Representative (Series 7) Practice Exam

When an investor writes a call option on stock they own, what is the maximum loss if the option expires?

1. The premium received for the option

2. The market value of the stock

3. His cost in the stock, less the premium

4. The strike price of the option

The correct answer is: His cost in the stock, less the premium

When an investor writes a call option on stock they own, also known as a covered call strategy, the maximum loss occurs if the option expires and the investor still holds the stock. In this case, the loss comes into play if the stock price decreases significantly. The investor initially paid a certain amount for the stock, known as the cost basis. When the call option is written, the investor receives a premium, which adds to their total return if the stock position remains unchanged. Therefore, if the option expires worthless (the underlying stock price is less than the strike price at expiration), the investor's potential loss is equal to the cost of the stock minus the premium received from writing the option. This means that option C reflects the correct understanding: the maximum loss is indeed the cost in the stock less the premium received. If the stock's market value drops significantly, the investor will be left with the devaluation of the stock, offset slightly by the premium received, which allows them to recover some losses. The reasoning behind this concept is crucial for investors employing options strategies, highlights the risk management aspects of stocks, and describes their potential outcomes in fluctuating markets.