Has anyone come up with a mnemonic for options?

CFA Level III
#1

I am sitting here trying to find a way to remember the profit formulas for all of the options discussed in the text. I’ve heard instructors say that this is an area you just plain have to memorize but surely someone more clever than me has thought of something better here than just purely memorizing the formulas?

Also, I am completely incapable of memorizing breakeven and max loss and max gain formulas for each of these. Is that something that will come back to bite me on the exam (on prior exams I don’t recall ever being asked that, so maybe that’s my answer) or is there some easy way to remember the formula in each case?

Ugh.

#2

I am not trying to memorize either. I am bad at memorizing in general, I am better skilled at understanding and redoing from scratch. I think that regarding this area you should go for what suits you best. If you can’t memorize it’s better to spend time training. This will never be wasted time anyways. And there is already SOOOOO MUCH to memorize for level III :-/

#3

If you know how to derive the profit formula (relatively easy), you should be able to derive the rest.

Also, being familliar with the pay-off shapes of each strategy helps a ton.

Example (Butterfly spread using calls):

You have:

2 long calls, Ch Cl

2 short calls, 2Cm

Profit: Max()St-Ch+Max()St-Cl-Max()2(St-Cm)-Chp-Clp+2Cmp

Easy so far.

Maximum profit is taking the first part of the equation (option pay-offs) and finding the value of St that gives you the largest number. It’s easy if you know the purpose of the strategy (and it’s payoff chart). Basically, maximize the positive signs, and minimize the negative ones.

In this case, we want the -2Max(St-Cm, 0) to equal zero. So, the max pay-off is at St=Cm. Substituting that in the profit formula gives you the maximum profit.

Same goes for maxmum loss.

For breakeven, you want the whole profit formula to equal zero, or in other words, the pay-offs equal the premiums, and solve for St. If it’s a zero-cost spread (which likely is) then solve for zero, which is the same as the maximum loss equation. Which gives you two breakevens. One at Cl, and the other at Ch (assuming Cm is the middle strike price).

Easy, no?

#4

Yeah I’d agree that it’s easier to actually understand the structure of each option strategy, understand what options are used in what buy/sell combination and then graph the payout diagram…then it’s easy just to use basic geometry to figure out 95% of the answers regarding max profit/loss/break even etc.

Remembering all those individual payout/max profit/loss/break even formula is a waste of brain space in my opinion.

#5

Yes I agree with MrSmart and S666 that if there is one thing at least that you should visualize right away and just retrieve from your memory, it’s the graph of the payout diagram. This one you shouldn’t hesitate on, otherwise you will lose too much time

#6

Here an example of how I present things to answer a question on values and profits at option expiration. I find that it allows to solve the problem fast and limits the risk of errors.

Take reading 27, EOC 2)b).

I would do the following table:

Expiration stock value 0.87 0.78 0.68

Long put (0.85) X V V

Short put (0.70) X X V

where X = out of the money

V = in the money

Value 0 0.07 0.17 - 0.02 = 0.15

Profit -0.15 + 0.03 = -0.12 0.07-0.12= -0.05 0.15- 0.12= 0.03

I find it fast because it’s easy to put the X and V. Then, as soon as you see a X you know you have nothing to compute to get the value. As soon as you see a V you know you have to compute the difference between the two figures you see. It should be a positive figure if you are long the option and a negative if you are short the option.

I hope this helps.

You can extend this table to a unlimited number of options (4 in the case of a butterfly spread for example). It makes it less likely that you will make an error.