Options Strategies

5 minutes 5 Questions

Options strategies are essential tools in a CFA Level 3 portfolio manager’s toolkit, allowing for enhanced income, hedging, and speculative opportunities. At the core, options are contracts granting the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before expiration. Key strategies include: 1. **Covered Call**: Involves holding the underlying asset while selling a call option. This generates income from the option premium but limits upside potential if the asset price rises above the strike price. 2. **Protective Put**: Entails purchasing a put option for an asset already owned. This acts as insurance against a decline in the asset’s price, providing downside protection while retaining upside potential. 3. **Straddle**: Consists of buying both a call and put option at the same strike price and expiration. This strategy profits from significant price movements in either direction, making it suitable in volatile markets. 4. **Strangle**: Similar to a straddle but uses different strike prices for the call and put. It is typically less expensive than a straddle and also benefits from substantial price movements. 5. **Iron Condor**: Combines a bull put spread and a bear call spread, aiming to profit from low volatility. It profits when the underlying asset remains within a specific price range, minimizing risk through defined spreads. 6. **Butterfly Spread**: Involves multiple options at different strike prices to create a profit zone around the middle strike. It is used to capitalize on minimal price movement with limited risk and reward. Effective implementation of these strategies requires a deep understanding of option Greeks, volatility, and market outlook. For CFA Level 3 candidates, mastering these strategies is crucial for advanced portfolio management, risk mitigation, and achieving specific investment objectives.

Options Strategies - CFA Level 3

Options strategies are important for CFA Level 3 candidates to understand as they are frequently tested on the exam. An option strategy involves combining different options positions to achieve a specific risk-return profile.

What are Options Strategies?
Options strategies involve taking positions in multiple options contracts simultaneously to create a desired risk-return profile. By combining different options positions (such as long calls, short puts, etc.), investors can profit from various market scenarios while potentially limiting downside risk.

How Options Strategies Work
Each options strategy has a unique payoff structure based on the underlying asset's price movement. For example, a bull call spread involves buying a call option and selling another call option with a higher strike price, limiting both potential profit and loss. The success of an options strategy depends on correctly predicting the direction and magnitude of the underlying asset's price change.

Answering Questions on Options Strategies
When answering questions about options strategies in the CFA Level 3 exam, it's essential to:
1. Identify the specific strategy being described
2. Understand the payoff structure and risk-return profile of the strategy
3. Recognize the market conditions in which the strategy would be most effective
4. Calculate the potential profit or loss at different price points of the underlying asset

Exam Tips: Answering Questions on Options Strategies
- Memorize the payoff structures of common options strategies (e.g., straddles, strangles, spreads)
- Practice calculating the profit or loss for each strategy at various price points
- Pay attention to the net position (long or short) and the overall risk-return profile
- Identify the breakeven points and maximum profit/loss for each strategy
- Understand how time decay and volatility affect the value of options strategies

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Question 1

An investor has a neutral to slightly bearish outlook on XYZ stock, which is currently trading at $50 per share. The investor wants to implement an options strategy that will generate income if the stock price remains stable or decreases slightly, while also providing some upside potential. The investor sells one XYZ 45 put option contract with a strike price of $45 and a premium of $2 per share, and simultaneously sells one XYZ 55 call option contract with a strike price of $55 and a premium of $1 per share. Both options have the same expiration date. What options strategy is the investor implementing, and what is the maximum profit potential of this strategy assuming the stock price remains at $50 at expiration?

The investor is implementing a short strangle strategy. The maximum profit potential is $300, which is the total premium received from selling the put and call options ($200 + $100 = $300), assuming the stock price remains between the strike prices of $45 and $55 at expiration. The investor is implementing a short butterfly spread. The maximum profit potential is $200, which is the total premium received from selling the put and call options ($200 + $100 = $300), assuming the stock price remains at the middle strike price of $50 at expiration. The investor is implementing a short straddle strategy. The maximum profit potential is $200, which is the total premium received from selling the put and call options ($200 + $100 = $300), assuming the stock price remains between the strike prices of $45 and $55 at expiration, and the investor does not face assignment risk on either option.

Correct Answer: The investor is implementing a short strangle strategy. The maximum profit potential is $300, which is the total premium received from selling the put and call options ($200 + $100 = $300), assuming the stock price remains between the strike prices of $45 and $55 at expiration.

The investor is implementing a short strangle strategy. A short strangle involves selling an out-of-the-money call option and an out-of-the-money put option with different strike prices but the same expiration date. The investor sells a put option with a strike price of $45 and a call option with a strike price of $55, both expiring on the same date. This strategy is suitable for a neutral to slightly bearish outlook, as the investor expects the stock price to remain stable or decrease slightly. The maximum profit potential is the total premium received from selling the put and call options. In this case, the investor receives $200 from selling the put option (1 contract × 100 shares per contract × $2 premium per share) and $100 from selling the call option (1 contract × 100 shares per contract × $1 premium per share). The total premium received is $300, which is the maximum profit potential if the stock price remains between the strike prices of $45 and $55 at expiration. The other strategies mentioned are incorrect because: - A short straddle involves selling a call and a put option with the same strike price and expiration date, which is not the case here. - A short butterfly spread involves selling one call and one put at a middle strike price, and buying one call and one put at an upper and lower strike price, respectively. This strategy is not applicable to the given scenario.

Question 2

An investor has a moderately bullish outlook on XYZ stock, which is currently trading at $40 per share. The investor believes the stock price will increase in the near future but wants to limit the potential loss if the stock price declines. The investor buys one XYZ 40 call option contract with a strike price of $40 and a premium of $3 per share, and simultaneously sells one XYZ 45 call option contract with a strike price of $45 and a premium of $1 per share. Both options have the same expiration date. What options strategy is the investor implementing, and what is the maximum profit potential of this strategy assuming the stock price rises to $50 at expiration?

The investor is implementing a bull call spread strategy. The maximum profit potential is $300, calculated as (($50 - $40) - ($3 - $1)) × 100 shares per contract, assuming the stock price rises to $50 at expiration and the investor exercises both options. The investor is implementing a bull call spread strategy. The maximum profit potential is $400, calculated as (($45 - $40) - ($3 - $1)) × 100 shares per contract. The investor is implementing a bear call spread strategy. The maximum profit potential is $200, calculated as (($45 - $40) - ($3 - $1)) × 100 shares per contract, assuming the stock price rises to $50 at expiration.

Correct Answer: The investor is implementing a bull call spread strategy. The maximum profit potential is $400, calculated as (($45 - $40) - ($3 - $1)) × 100 shares per contract.

The investor is implementing a bull call spread strategy. In this strategy, the investor buys a call option with a lower strike price and simultaneously sells a call option with a higher strike price, both having the same expiration date. This strategy is used when the investor has a moderately bullish outlook on the stock. To calculate the maximum profit potential, we need to find the difference between the strike prices of the two options and subtract the net premium paid. The investor bought the $40 call for $3 and sold the $45 call for $1, resulting in a net premium of $2 per share. Maximum profit = (Higher strike price - Lower strike price) - Net premium paid Maximum profit = ($45 - $40) - ($3 - $1) Maximum profit = $5 - $2 = $3 per share Since each option contract represents 100 shares, the maximum profit potential is $3 × 100 = $300. The other answers are incorrect because they either misidentify the strategy or miscalculate the maximum profit potential.

Question 3

An investor has a neutral to slightly bullish outlook on STU stock, currently trading at $60 per share. The investor wants to generate income while potentially profiting from a moderate increase in the stock price. To implement this strategy, the investor sells one STU 55 put option contract with a strike price of $55 and a premium of $2 per share, and simultaneously sells one STU 65 call option contract with a strike price of $65 and a premium of $1.50 per share. Both options have the same expiration date. What options strategy is the investor implementing, and what will be the profit or loss if the stock price rises to $70 at expiration?

The investor is implementing a long strangle strategy. If the stock price rises to $70 at expiration, the 55 put will expire worthless, and the 65 call will be exercised, resulting in a profit of $1.50 per share (($70 - $65) - $2 premium paid for the put - $1.50 premium paid for the call) or $150 per contract. However, the investor's total profit will be reduced by the premiums paid for both options. The investor is implementing a short straddle strategy. If the stock price rises to $70 at expiration, the 55 put will expire worthless, and the 65 call will be exercised, resulting in a loss of $1.50 per share (($65 - $70) + $2 premium received from the put + $1.50 premium received from the call) or $150 per contract. The investor is implementing a short strangle strategy. If the stock price rises to $70 at expiration, the 55 put will expire worthless, and the 65 call will be exercised, resulting in a loss of $3.50 per share (($65 - $70) + $1.50 premium received) or $350 per contract.

Correct Answer: The investor is implementing a short strangle strategy. If the stock price rises to $70 at expiration, the 55 put will expire worthless, and the 65 call will be exercised, resulting in a loss of $3.50 per share (($65 - $70) + $1.50 premium received) or $350 per contract.

The investor is implementing a short strangle strategy. A short strangle involves selling an out-of-the-money call option and an out-of-the-money put option simultaneously, with the same expiration date but different strike prices. In this case, the investor sells a 55 put (below the current stock price of $60) and a 65 call (above the current stock price). The investor receives premiums of $2 per share for the put and $1.50 per share for the call. If the stock price rises to $70 at expiration, the 55 put will expire worthless, and the investor keeps the $2 premium. However, the 65 call will be exercised, and the investor will have to sell shares at $65 while the market price is $70. This results in a loss of $5 per share on the call, offset by the $1.50 premium received, for a net loss of $3.50 per share. With 100 shares per contract, the total loss on the call is $350 per contract. The investor keeps the $200 premium from the put, resulting in an overall loss of $150 per contract. The other strategies mentioned are incorrect because: - A short straddle involves selling both a call and a put with the same strike price, which is not the case here. - A long strangle involves buying an out-of-the-money call and put, whereas the investor is selling these options.

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