CFA Level III - Option strategies - How to calculate max profit, max loss, break even for various option strategies intuitively instead of memorizing formulas in curriculum?

The derivatives topic covers strategies namely - covered call, protective put, collar, straddle, risk reversal, bull and bear spreads, calendar spreads and reverse of each.

For each strategy we need to know to calculate max profit, max loss, break even.

Is there a way to calculate the same intuitively for all the above without memorizing formulas?

Yes assume extreme values for stocks

This is a method I used in b-school and still use for CFA work.

Draw a sideways T and put + above and - below the line. Maybe something like this


Then, think graphically about what would actually happen when buying/selling puts or calls. Let’s try a couple of examples.

If you buy for $5 a call on a stock with a strike of $40, you can draw a line (from left to right) BELOW the main line (as it cost you $5, so you’re negative at the moment). Assuming the stock goes above $40, you then START to move up and to the right, getting above the $0 line at $45. This makes sense as the option cost you $5 in the first place, so you need the stock to be ABOVE $45 to make any profit.

Let’s try selling a put. In this case, we RECEIVE $5 (assuming option premium is $5) so we start out positive, so above the line. Again, we’ll stick with the $40 strike price to keep it simple. Now, we’re drawing our line from RIGHT to LEFT (as this is a PUT) and can see that we stay profitable as long as the stock is above $40. Once it gets to $40, we start losing money, and for the person that bought the put, they start becoming profitable. For example, if the stock ends at $20, then for us the end profit is +$5 (premium we took in) and -$20 (cost to buy the stock on the market for the person who exercised the put). All in, +$5 - $20 = -$15 loss.

Hope this is helpful.

But why do you need to memorise options strategy in the first place ? I am pretty sure the exam never asks you to decode a strategy since they do not expect you to know what is Bill Call spread or what is a butterfly strategy. They would mention every detail you need to know to solve a problem.

They do, actually.


Look here for a start: Bear Spread | Financial Exam Help 123