Option Strategy - help...

CFA Level III
#1

It has to be easier way to figure out maximum profit, loss, and break even for those option strategies rather than memorizing x0 + c0, BS!! Anyone??

I get that positions and how to value the profits, but trying to figure our MP, ML, BE for each strategy is giving me a headache…

Can anyone help??

#2

learn the diagrams and the rest is intuitive

#3

+1

#4

Agreed. If you know all the parts of each strategy, you can price each and figure it out pretty quickly, no memorization of formulas required.

#5

Max payoff of a covered call? Max payoff of a box spread?

#6

box = risk free rate

#7

Max profit of a covered call? --> premium on call sold + (X-S0) Max profit of a box spread? --> risk free rate provided no arbitrage opportunity. Buy box spread if you think options are underpriced and sell box spread if you think options are overpriced to make arbitrage profit.

– Updated payoff to profit to avoid confusion.

#8

Seriously??

Can you guys explain it in more detail? It will be really appreciated. I am little struggling with this section.

Thank you,

#9

Isn’t payoff = value at maturity

#10

I can help. What strategies are you particularly interested in? I’ll show u how I’ve done it and probably u can try it for the rest.

#11

Ok, let’s do the bull spread and see if I can figure out rest.

Thanks so much.

#12

ok so now think of a bull call spread: You buy a call with a low exercise price XL and sell a call with a high exercise price XH.

You should always ask for three questions while determining the formulas:

  1. How much did you spend on the strategy? (Net Premium) (associate with maximum loss)

  2. What did you expect from the strategy? (stock price ranges that won’t hurt you)

  3. What should be the stock price that would help you recover your cost?

Let’s then decide what can be the maximum loss?

say none of the calls were in the money (which is usually the case here) and the stock price went to 0 so that nothing ended up being in the money. (most strategies have max loss = net premium)

You’ll lose all that went into your strategy. That is your net premium.(Cost of long option - cost of short option)

Now think of break even. You’d want to benefit only to the extent that whatever you spent must be recovered.

(what should be the stock price that would help recover the cost)

So the purchased option should finish in the money by an amount equal to cost of strategy.

XL + (net premium) or XL + (C0L - COh)

Now think of what did you expect from the strategy? Your intent was to gain from the long option and the short option was used to finance the long option but it will limit your upside by the high exercise price.

So the maximum you will gain is at the point where the second option will start being in the money. That point is the higher exercise price. So you start making money when you exceed the low exercise and reach the high exercise. Hence that band of money is XH-XL. Now this money making ability came at a cost = net premium,

so max profit = XH - XL - (net premium)

= XH - XL - (CoL - CoH) = XH - XL - CoL + CoH

I just hope i didn’t make any mistakes because didn’t review it before posting. I’d be embarassed if there’s a stupid mistake. But I guess this is correct. I hope this helps.

#13

Hi, Can someone plz explain the break-even price for butterfly spread. There are two break-even prices? How to arrive at these prices especially the second one.

#14

Butterfly Spread

It consists of a bull spread (as described above) on lower pair of strikes and a bear spread on the higher pair of strikes. Although there are two pairs, there are only three strike prices (so two of the options share the same strike) and they are equally spaced apart.

  • Net initial (negative) cash flow = max loss
  • Difference between max loss and max profit = difference between adjacent strikes
  • Breakeven = lowest strike + max loss and highest strike - max loss

Keep in mind, the butterfly spread can be either long or short (short involves reversing all of the options). The long payoff will resemble a capital A (only the top of the A is in the money) and the short payoff will resemble the Van Halen V, with only the top portion of the V in the money.

#15

I spent all this afternoon, and I finally got it what you meant by ‘learn the diagrams.’

I am so relieved, now that I do not have to remember all those BS max. profit, loss, and BE formulae. When you know the diagrams, all those calculations are a simple algebra. Thanks for the tip…

My brain hurts… going to bed, but feel much better and relieved.

#16

use the graph. Memorize the structure of each strategy. It would be easier.

Hard thing is to give you a scenario, and let you choose the best strategy…

#17

learned them by heart to be honest.