Option formulae

Hi - anyone got recommendations how to recall the payoffs, maximum gain, loss, break even etc for all the different combinations, Bull/ bear spread, butterfly, straddle etc. Thank in advance!

  1. You have to learn from which position each strategy is made of (eg. Protective Put = Long Stock, Long Put etc).

  2. Also you have to learn the limits of each strategy (limited upward, downward etc…)

  3. Then you would be able to construct option value position. Adding, deducting premiums from option value you reach Option profit.

  4. From there and knowing each position limits you may play by simulating extreme scenarios (eg. St = 0 or St = 10000) and plugging into Option Profit formulae so you would easy find Max. Gain and Max. Loss. Be aware, those are heding strategies so Max loss and Max Gain are limited and in small amounts often referred only as premium cost loss/gain.

  5. To calculate break even, first from Option Profit formula (under 3. above) calculate net premium cost for option buyer if there is no underlying in certain spread and then simulate value of St from options payoff which will offset net option cost to zero. This is breakeven price. If there is underlying held in certain position you have to include changes in underlying price which will offset option gain/losses to 0.00.

Sounds complicated but actually isn’t. You should recall a Put- Call parity. Understanding payoff diagrams may be an advantage but, IMO is not required to understand option positions.

Also to add to Flashback’s stuff… I personally always look at it from the buyers perspective so my sign positions are consistent. Then if the question is asking for sell side just reverse the sign. Because once you get to later readings there is just more stuff in reference to a buyer / seller, borrower / lender, and it all gets confusing. But you just gotta know it

Thank you both

I wrote a series of articles on option strategies: how to construct them, what the payoffs are, how to compute the breakeven points and minimum and maximum payoffs: the works. You can find them here: http://financialexamhelp123.com/level-iii-risk-management-applications-of-derivatives/.

(Full disclosure: as of 4/25/16 there is a charge to read the articles on my website. You can get an idea of the quality of the articles by looking at the free samples here: http://www.financialexamhelp123.com/sample-articles/.)