General Securities Representative (Series 7) Practice Exam

What is the best method to both protect and generate income using options?

1. Write long puts

2. Write calls against the index

3. Buy protective puts

4. Sell covered calls

The correct answer is: Write calls against the index

The best method to both protect and generate income using options is to sell covered calls. This strategy involves owning the underlying stock and simultaneously writing (selling) call options on that same stock. By doing this, the investor can generate income through the premium received from selling the call options. When selling covered calls, if the stock price remains below the strike price of the written call option at expiration, the calls expire worthless, and the investor keeps the premium as income. This not only provides a level of ongoing income but also can help provide some downside protection by offsetting potential losses with the premium received. If the stock price rises above the strike price, the stock may be called away, and the investor still realizes a profit on the stock itself, along with the premium collected. This creates a balance between generating income and being willing to sell the shares at a predetermined price. In contrast, while other options such as writing long puts or buying protective puts may provide some forms of risk management or income generation, they do not combine these benefits as effectively as the covered call strategy does. Writing calls against the index specifically focuses on generating income without the same level of ownership, and may not provide the same protection as the covered call strategy associated with individual stocks.