cfa-program2025L3V4 Derivatives-output

  • Options Strategies Overview

Learning Outcomes

  • Demonstrate how asset returns may be replicated using options.

  • Discuss the investment objectives, structures, payoffs, risks, and breakeven prices of:

    • Covered call positions

    • Protective put positions

    • Various option strategies: bull spread, bear spread, straddle, collar.

  • Analyze the delta of various positions including covered calls and protective puts compared with being long an asset or short a forward.

  • Examine volatility skew and smile.

  • Identify appropriate option strategies based on investment objectives.

Introduction to Derivatives

  • Definition: Financial instruments allowing counterparties to exchange economic cash flows based on underlying securities or indices.

  • Derivatives are categorized into directly created contracts and exchange-traded types, with different liquidity and risk characteristics.

  • Options: A type of contingent claim that grants the holder the right, but not the obligation, to a payoff defined by the future price of the underlying asset.

  • Unlike swaps or futures, options have nonlinear payoffs.

Key Option Strategies

Covered Call Strategy

  • Definition: Selling a call option on an asset already owned.

  • Objectives: Enhance yield, mitigate risk, or realize share value at a target price.

  • Max Profit: Option strike price plus premium received.

  • Max Loss: Limited to the decline in asset value minus the option premium received.

Protective Put Strategy

  • Definition: Buying a put option to secure downside protection on an owned asset.

  • Payoff Structure: Provides insurance against declines in the asset price.

  • Max Loss: Value of underlying asset declines to put strike price, plus premium paid for the put.

Spread Strategies

  • Bull Spread: Buy a call and sell another call with a higher strike price.

    • Aim: Profit from a price increase while limiting risk.

  • Bear Spread: Buy a put and sell another put at a lower strike price.

    • Aim: Profit from price declines.

  • Max Gain: Limited to the difference in strikes minus initial cost.

Straddle Strategy

  • Definition: Buy both a call and put at the same strike price and expiration.

  • Purpose: Profiting from significant movements in either direction.

  • Breakeven Points: Stock price must move significantly to cover the cost of both premiums.

Collar Strategy

  • Definition: Comprising a long stock position, a purchased put for downside protection, and a written call for income.

  • Benefit: Limits downside risk while capping upside potential.

  • Utilizes premiums from call sales to offset put costs, creating a zero-cost collar.

Calendar Spread Strategy

  • Definition: Buying and selling the same type of option (call or put) with different expiration dates.

  • Strategy Use: Capitalizing on time erosion and volatility shifts.

  • Price Movement: Designed for minimal price movement in the short term while aiming for larger gains from the long option.

Volatility Considerations

Implied Volatility

  • Reflects market expectations; crucial for pricing options.

  • Volatility Skew: Typically seen where OTM puts are more expensive than OTM calls.

  • Strategies can be tailored based on expected changes in implied volatility.

Summary of Investment Objectives

  • Set realistic objectives according to risk appetite and market outlook.

  • Understand the implications of options Greeks (Delta, Gamma, Vega, Theta) on strategies employed.

  • Consider situations under which certain strategies become favorable or unfavorable.

  • Strategies vary from hedging against declines, capturing volatility, and directing target price actions.