Easy way to remember Derivatives

CFA Level III Derivatives
#1

Hi everyone,

I have found very good advice on this forum on how to remember the payoff graphs of derivatives like Bull Call, Bear Put etc.

But is there an easy way to remember whether the instruments used to make up these instruments should be In the Money, Out of the Money or At the Money?

For example, a Bull Call is supposed to be made up of a ITM Long Call and a OTM Short Call. I can’t figure out why this is so.

Thank you!

#2

HI there. I’m not an expert on the topic but I’ll add my input. There’s no requirement for the long call to be ITM and the short call to be OTM. The requirement is that the long call needs to be closer to being ITM than the short put such that the premium earned on the short put is less than the premium paid on the long call so that the transaction results in a net debit position.

I usually start with identifying if the position is a net credit or debit then I can determine the strike prices for the long and short legs of the spread.

Bull put = net credit

Bull call = net debit

Bear put = net debit

Bear call = net credit

#3

Thanks for the reply, can you please explain

  1. how did you know about the requirement?

  2. how did the short put come into play? The Bull Call was referring to long call and short call.

Thanks

#4

Try with that way:

Bull Call or Put = Buy Low sell High (strike option)

Bear Call or Put = Buy High Sell Low

Box = Bull + Bear, earn an arbitrage profit if exists

Straddle = Buy ATM Put + ATM Call on same X, bet on volatility

Strangle = Same as Straddle but cheaper version ‘cause you are playin’ with OTM Put and Call

Reverse (short) strangle (straddle) = You are betting against volatility

Butterfly = Buy Low, Buy High, short two Mid strike options,almost totally hedged position

Collar = protective put and sell call to pay for put, if you offset cost of put in total, you got 0 - price collar

#5

Thanks for the reply. Any possibility of dumbing this down further?

For example, with your first statement:

Bull Call or Put = Buy Low sell High (strike option)

How does this tell me what should be ITM, OTM or ATM?

#6

You do not need remember this. You must be able to calculate break even point (ATM), maximum profit and maximum loss of each position. Reasoning positions as described above gives you a starting point to get the option values for each spread with premium added or deducted (words inputs in the form of buy or sell). Then simply simulate each scenario by writing equations (my approach) or drawing a position graphs (common approach here).

#7

Thanks for the reply. May I know why you say we don’t have to remember this?

The reason why I started this topic was after I read the following question. It seems to require you to know that you are supposed to use ATM options.

Thank you once again.

Question

The EUR is trading at USD 1.035. A trader expects the EUR to become much more volatile than reflected in current option prices. Puts and calls on the EUR are available. Puts with a strike of USD 0.98 are trading at USD 0.005 and with a strike of USD 1.04 are trading at USD 0.017. Calls with a strike of USD 0.98 are trading at USD 0.068 and with a strike of USD 1.04 are trading at USD 0.004. Compute the breakeven price or prices of the correct option strategy.

Answer

Buy ATM puts and calls on the EUR. The 1.04 strike price is the closest to ATM. Buying the call and put will cost: 0.004 + 0.017 = 0.021. Looking at the graph for a straddle, this is the max loss and occurs if the EUR closes at 1.04. For breakeven prices, the EUR must decrease or increase 0.021 to USD 1.019 or 1.061.

#8

Personally, I think that the best approach is to learn the shape of the payoff diagrams, then build whichever one you need on the fly, rather than trying to memorize what options you need for each strategy.

  • Bull spread: _/¯
  • Bear spread: ¯_
  • Long straddle: /
  • Short straddle: /\
  • (Long) strangle: _/
  • Short strangle: /¯\
  • (Long) butterfly: _/_
  • Short butterfly: ¯/¯
  • And so on

If you need to build one of these things, start somewhere and move up or down:

  • Bull spread
    • If you start at the left and move right, you need an upward kink (long call), then, later, a downward kink (short call)
    • If you start at the right and move left, you need a downward kink (short put), then, later, an upward kink (long put)
  • (Long) butterfly
    • If you start at the left and move right, you need an upward kink (long call), then, later, two downward kinks (one to get back to level, the other to go down: two short calls), then, later, an upward kink (long call)
    • If you start at the right and move left, you need an upward kink (long put), then, later, two downward kinks (one to get back to level, the other to go down: two short puts), then, later, an upward kink (long put)
  • And so on

As for which are in-the-money and which are out-of-the-money, just remember that you generally want the spot price to be somewhere in the middle of the funny business; i.e., you want one or more kinks to the left of (lower strike than) the spot price and one or more kinks to the right of (higher strike than) the spot price.

#9

You just need to know what is a straddle as I mentioned in my first post.

Hence, the trader is expecting that the FX market become more volatile, the correct strategy is betting on volatility. Hence, straddle should be an optimal position.

If you know that straddle is constructed by buying ATM call and put with same strike on same underlying, you will chose those options which strikes are quite near current underlying price, S.

With current position the value of u put is 0,05 above the current underlying spot price and the value of a call is 0,05 below spot price.

The BE with straddle strategy is therefore= Max (S - X, 0) + Max (X-S, 0) - C -P = 0 hence

= Max (1,035 - 1,04 ) + Max (1,04-1,035) -0,017-0,004 = 0

To reach the break even point you should cover both premium costs and this is eqal $ 0,021.

Since put position value is already worth 0,05 , the underlying price should decline further for (+ 0,021 - 0,05) = 0,016 or

1,035 - 0,016 = 1,019 to put value increase to cover the premium costs.

thus BE 1

= Max (1,035-1,04, 0) + Max ( 1,04- 1,019 ) -0,017-0,004 = 0

to calculate BE 2

Since call position is already - 0,05 below current market price, the price should rise further for (+ 0,021 + 0,05) = 0,026 or

1,035 + 0,026 = 1,061 to cover the premium costs.

thus BE 2

= Max ( 1,061 -1,04, 0) + Max ( 1,04- 1,061, 0 ) -0,017-0,004 = 0

Another available options strategy is not applicable for betting on volatility in this case, With X = $ 0,98, Call is already deeply ITM while Put is deeply OTM and entering into such position will not be appropriate given the trader’s expectations.

#10

Hey there.

  1. it’s not so much a requirement but just a natural result of the offsetting premiums that are netted when you buy the more expensive call (because it’s closer to being ITM or is actually ITM) and sell the less expensive call (because it’s less ITM or more OTM). In this strategy the long call will have a lower strike price than the short call so it’ll be more expensive.

  2. Apologies. I meant to type short call not put.

#11

Thank you for the detailed explanation!

#12

Many thanks! This is immensely helpful!

#13

come exam day, I’ll probably just end up remembering this ¯_(ツ)_/¯

#14

That’s technically an IDK long strangle.

:wink:

#15

OMG, this thread just went to 11 for me!!! :grin: :+1:

#16

Thanks S2000magician, at least I’m 100% positive I won’t be forgetting what a long strangle looks like now!

#17

This is great!

My approach has been to remember what each of the strategy includes (i.e. buy/sell call/put) and then derive my own max, profit, loss & breakeven equations (After a few times, these have become pretty intuitive)

But Looks like payoff is the way to go…Would like to clarify a couple of items though:

  1. We still need to remember the payoff diagrams though, right?

The curriculum also does the payoff diagram + equations

  1. Now, looking at EoCs, i just find myself being not sure/comfy as to how to apply payoff on these questions vs. when i have equations handy (derived), these questions can be solved pretty quick

(vs. the payoff diag approach), where you will have to plot the numbers and then arrive at break even prices, max profit etc).

Am i missing something on this rather popular approach (payoff)?

Thanks