General Securities Representative (Series 7) Practice Exam

What strategy is primarily used to generate income through options?

1. Write covered calls

2. Buy calls

3. Buy puts

4. Write naked puts

The correct answer is: Write covered calls

Writing covered calls is a strategy primarily used to generate income. This strategy involves holding a long position in an underlying security and simultaneously selling call options on that same security. When the call options are sold, the investor collects the option premium, which generates immediate income. This technique is particularly appealing to investors who believe that the underlying stock will remain relatively stable or increase moderately in price. By writing covered calls, the investor can earn income from the option premium while potentially benefiting from any capital appreciation of the underlying stock. However, if the stock price rises significantly beyond the strike price, the investor may miss out on potential gains, as the stock may be called away. Buy calls and buy puts focus on potential profit from price movements in the underlying asset rather than generating income. Buying calls is a bullish strategy, aiming for profit if the stock price increases, while buying puts is a bearish strategy, profiting if the stock price decreases. Writing naked puts involves selling put options without holding a corresponding short position in the underlying asset. While this can also generate income through premiums, it carries significant risk if the underlying stock price falls considerably, as the seller may be obligated to buy the stock at the strike price. In summary, writing covered calls is the correct answer as it