LM1 Options Strategies 2024 Level III Notes

LM1 Options Strategies

1. Introduction ........................................................................................................................................................ 3
2. Position Equivalencies .................................................................................................................................... 3
Synthetic Forward Position ......................................................................................................................... 3
Synthetic Put and Call .................................................................................................................................... 7
3. Covered Calls and Protective Puts .......................................................................................................... 10
Investment Objectives of Covered Calls ............................................................................................... 10
4. Investment Objectives of Protective Puts ............................................................................................ 13
5. Equivalence to Long Asset/Short Forward Position........................................................................ 15
Writing Puts .................................................................................................................................................... 16
6. Risk Reduction Using Covered Calls and Protective Puts .............................................................. 17
7. Spreads and Combinations ........................................................................................................................ 19
Bull Spreads and Bear Spreads................................................................................................................ 19
8. Straddle ............................................................................................................................................................. 23
Collars ............................................................................................................................................................... 25
Calendar Spread ............................................................................................................................................ 26
9. Implied Volatility and Volatility Skew ................................................................................................... 27
10. Investment Objectives and Strategy Selection ................................................................................ 29
The Necessity of Setting an Objective ................................................................................................... 29
Criteria for Identifying Appropriate Option Strategies.................................................................. 29
11. Uses of Options in Portfolio Management ......................................................................................... 30
Covered Call Writing ................................................................................................................................... 30
Put Writing ...................................................................................................................................................... 31
Long Straddle ................................................................................................................................................. 31
Collar.................................................................................................................................................................. 33
Calendar Spread ............................................................................................................................................ 33
12. Hedging an Expected Increase in Equity Market Volatility ........................................................ 34
Establishing or Modifying Equity Risk Exposure ............................................................................. 34
Summary................................................................................................................................................................ 36

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LM1 Options Strategies 2024 Level III Notes

This document should be read in conjunction with the corresponding reading in the 2024 Level III
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
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LM1 Options Strategies 2024 Level III Notes

1. Introduction
A derivative is a financial instrument that derives its value from the economic performance
of the underlying (stocks, interest rate, etc.). Options are contingent-claim derivatives. The
two main types of options are call options and put options.
• A call option gives the holder a right but not the obligation to buy the underlying
asset at a particular price.
• Similarly, a put option gives the holder a right but not the obligation to sell the
underlying asset at a particular price.
Section 2 of this reading covers position equivalencies – how two or more securities can be
combined to create another security. Sections 3 -6 cover the two most widely used options
strategies – covered calls and protective puts. Sections 7 and 8 cover other popular options
strategies – spreads and combinations. Section 9 discusses implied volatility embedded in
option prices and volatility skew. Section 10 discusses how to select an appropriate option
strategy to achieve a particular investment objective. Sections 11 and 12 cover the uses of
options in portfolio management.
2. Position Equivalencies
In this section, we will outline how certain combinations of derivatives are equivalent to
other assets/portfolios. At earlier levels, we covered two important position equivalence
relationships:
• Put-call parity: A fiduciary call is equivalent to a protective put.
i.e. S0 + p0 = c0 + X/(1 + r)T
• Put-call-forward parity: Here we replace S0 with a forward contract to buy the
underlying. The forward price is given by F0(T) = S0(1 + r)T, therefore the put-call
parity formula changes to:
F0(T)/(1 + r)T + p0 = c0 + X/(1 + r)T
Synthetic Forward Position
Synthetic Long Forward Position
Buying a call and writing a put on the same underlying with the same strike price and
expiration creates a synthetic long position (or, a synthetic long forward position). This can
be demonstrated by looking at the payoffs of the three alternatives:
1) Buy a call and write a put. Both options have the same expiration date and the same
exercise price of $50.
2) Buy a stock for $50.
3) Buy forward/futures at 50.

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LM1 Options Strategies 2024 Level III Notes

Stock price at expiration: 40 50 60

Alternative 1: Long call, short put
Long call payoff 0 0 10
Short put payoff –10 0 0
Alternative 1 payoff –10 0 10
Alternative 2: Long stock at 50
Alternative 2 payoff –10 0 10
Alternative 3: Long forward/futures at 50
Alternative 3 value –10 0 10
The table above shows that all three alternatives have the same payoff (value). Hence, we
can conclude that: Long call + Short put = Long stock = Long forward/futures
Another method to evaluate the alternatives is to draw their payoff diagrams.
Payoff of a Long stock (or Long forward/futures)

Payoff of a Long call + Short put

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LM1 Options Strategies 2024 Level III Notes

Synthetic Short Forward Position

Selling a call and buying a put on the same underlying with the same strike price and
expiration creates a synthetic short position. This can be demonstrated by looking at the
payoff diagrams of the alternatives:
Payoff of a short stock (or short forward/futures)

Payoff of Long put + Short call

Hence, we can conclude that: Long put + Short call = Short stock = Short forward/futures

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LM1 Options Strategies 2024 Level III Notes

Synthetic positions are used:

1. To exploit arbitrage opportunities, when the actual forward contract is over or
undervalued as compared to the implied synthetic contract.
2. When it is difficult to buy an actual forward contract.
Example: Synthetic Long Forward Position vs. Long Forward/Futures
(This is Example 1 from the curriculum.)
A market maker has sold a three-month forward contract on Vodafone that allows the client
(counterparty) to buy 10,000 shares at 200.35 pence (100p = £1) at expiration. The current
stock price (S0) is 200p, and the stock does not pay dividends until after the contract
matures. The annualized interest rate is 0.70%. The cost (i.e., premium) of puts and calls on
Vodafone is identical.
1. Discuss (a) how the market maker can hedge her short forward position upon the sale of
the forward contract and (b) the market maker’s position upon expiration of the forward
contract.
2. Discuss how the market maker can hedge her short forward contract position using a
synthetic long forward position and explain what happens at expiry if the Vodafone share
price is above or below 200.35p.
Solution 1:
a. To offset the short forward contract position, the market maker can borrow ₤20,000 (=
10,000 × S0/100) and buy 10,000 Vodafone shares at 200p. There is no upfront cost
because the stock purchase is 100% financed.
b. At the expiry of the forward contract, the market maker delivers the 10,000 Vodafone
shares she owns to the client that is long the forward, and then the market maker repays
her loan. The net outflow for the market maker is zero because the following two
transactions offset each other:
Amount received for the delivery of shares: 10,000 × 200.35p = £20,035
Repayment of loan: 10,000 × 200p [1 + 0.700% × (90/360)] = £20,035
Solution 2:
To hedge her short forward position, the market maker creates a synthetic long forward
position. She purchases a call and sells a put, both with a strike price of 200.35p and expiring
in three months.
At the expiry of the forward contract, if the stock price is above 200.35p, the market maker
exercises her call, pays £20,035 (=10,000 × 200.35p), and receives 10,000 Vodafone shares.
She then delivers these shares to the client and receives £20,035.

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LM1 Options Strategies 2024 Level III Notes

At the expiry of the forward contract, if the stock price is below 200.35p, the owner of the
long put will exercise his option, and the market maker receives the 10,000 Vodafone shares
for £20,035. She then delivers these shares to the client and receives £20,035.
Synthetic Put and Call
Synthetic Put
A synthetic long put position consists of a short stock and long call position in which the call
strike price equals the price at which the stock is shorted.
This can be demonstrated by looking at the payoff associated with the two alternatives.
Stock price at expiration: 40 50 60
Alternative 1: Short stock at 50 and Long 50-strike call
Short stock payoff 10 0 -10
Long call payoff 0 0 10
Alternative 1 payoff 10 0 0
Alternative 2: Long 50-strike put
Alternative 2 payoff 10 0 0
We can also look at the payoff diagrams of the two alternatives.
Payoff of Long put

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LM1 Options Strategies 2024 Level III Notes

Payoff of Short stock + Long call

Hence, we can conclude that: Long put = Short stock + Long call
Synthetic Call
A synthetic long call position consists of a long stock and long put position in which the put
strike price equals the price at which the stock is purchased.
This can be demonstrated by looking at their payoff diagrams.
Payoff of Long call

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LM1 Options Strategies 2024 Level III Notes

Payoff of Long stock + Long put

Hence, we can conclude that: Long call = Long stock + Long put
Example: Synthetic Long Put
(This is Example 2 from the curriculum.)
Three months ago, Wing Tan, a hedge fund manager, entered into a short forward contract
that requires him to deliver 50,000 Generali shares, which the fund does not currently own,
at €18/share in one month from now. The stock price is currently €16/share. The hedge
fund’s research analyst, Gisele Rossi, has a non-consensus expectation that the company will
report an earnings “beat” next month. The stock does not pay dividends.
1. Under the assumption that Tan maintains the payoff profile of his current short forward
position, discuss the conditions for profit or loss at contract expiration.
2. After discussing with Rossi her earnings outlook, Tan remains bearish on Generali. He
decides to hedge his risk, however, in case the stock does report a positive earnings
surprise. Discuss how Tan can modify his existing position to produce an asymmetrical,
risk-reducing payoff.
Solution 1:
If Tan decides to keep the current payoff profile of his position, at the expiry date, given a
stock price of ST, the profit or loss on the short forward will be 50,000 × (€18 – ST). The
position will be profitable only if ST is below €18; otherwise the manager will incur in a loss.
Solution 2:
Tan decides to modify the payoff profile on his short forward position so that, at expiration,
it will benefit from any stock price decrease below €16 while avoiding losses if the stock

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LM1 Options Strategies 2024 Level III Notes

rises above that price. He purchases a call option with a strike price €16 and one month to
maturity at a cost (premium) of €0.50. At expiration, the payoffs are as follows:
• On the short forward contract: 50,000 × (€18 – ST)
• On the long call: 50,000 × {Max[0,(ST – €16)] – €0.50}
• On the combined position: 50,000 × {(€18 – ST) + [Max[0,(ST – €16)] – €0.50]}
If ST ≤ €16, the call will expire worthless and the profit will amount to 50,000 × (€18 − ST + 0
− €0.50).
If ST > €16, the call is exercised, and the Generali shares delivered for a maximum profit of
50,000 × (€18 − €16 − €0.50) = €75,000.
3. Covered Calls and Protective Puts
Option Greeks:
• Delta is the change in an option’s price for a given small change in the value of the
underlying instrument, all else equal. Delta for long calls is always positive and delta
for long puts is always negative.
• Gamma is the change in an option’s delta for a given small change in the value of the
underlying instrument, all else equal. Gamma for long calls and long puts is always
positive.
• Vega is the change in an option’s price for a given small change in volatility of the
underlying, all else equal. Vega for long calls and long puts is always positive.
• Theta is the daily change in an option’s price, holding all else constant. Theta for long
calls and long puts is generally negative.
Consider Exhibit A showing the premium for options on IFT stock which currently sells for
$16.
Exhibit A: IFT Option Premiums: Current IFT stock price = 16.00
Calls Exercise Puts
SEP OCT NOV Price SEP OCT NOV
1.64 3.00 3.44 15 0.65 1.00 1.46
0.94 2.00 2.90 16 1.14 1.50 1.96
0.51 1.00 1.44 18 1.76 2.00 2.59
With respect to terminology, when we say ‘IFT October 15 call sells for 3.00’, the expiration
is October, the exercise price is 15, the option is a call, and the call premium is 3.00.
Investment Objectives of Covered Calls
A covered call is an option strategy in which an investor who owns a stock, sells a call option
on that stock. It is known as a covered call because the short call position is ‘covered’ by
owning the underlying stock. Hence: Covered Call = Long Stock + Short Call.

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LM1 Options Strategies 2024 Level III Notes

The investment objectives of covered calls are:

• Yield enhancement
• Reducing position at a favorable price
• Target price realization
Yield Enhancement
The most common reason for writing covered calls is that it provides an additional source of
income in the form of the option premium. However, this income comes at a cost. If the
stock price rises above the exercise price at expiry the call writer needs to deliver shares and
gives up capital gains of (S – X) to the call buyer.
Scenario: Suppose a stock is trading at $16. An investor who owns this stock believes that
the stock will remain stable over a certain time period. He does not want to sell the stock, but
he wants to generate additional cash. He writes a SEP 18 call and collects the premium of
$0.51. This represents an income for the investor. If the stock price increases from $16 to
$18 the investor benefits. However, any stock appreciation above the strike price of $18
does not benefit the investor. The gain in stock price is canceled out by what the investor
owes on the short call position.
Reducing Position at Favorable Price
If an investor has decided to sell a stock, he can use a covered call to effectively receive more
than the current market price of the stock.
Scenario: Using the data in Exhibit A, the IFT stock is at $16.00 and OCT 15 calls sell for 3.00.
An investor who has decided to sell IFT can sell OCT 15 call options. He will receive $3 when
he writes the option and $15 when the option is exercised. Overall, he’ll effectively receive
$3 + $15 = $18 for the stock which is better than the market price of $16. However, the risk
with this strategy is that if the stock price falls below $15, the options will expire out of the
money and the investor may have to sell the stock at a lower price than originally
anticipated.
Target Price Realization
A third popular use of covered calls is a hybrid of the first two objectives. Here investors
write calls with an exercise price near the target price for the stock.
Scenario: Suppose the IFT stock is trading at $15.80 but its target price is $16.00. An investor
might choose to write SEP 16 calls and receive a premium of 0.94 (from Exhibit A). If the
stock rises above 16 in a month, the stock will be sold at its target price. Through this
strategy, the investor sells the stock at the target price and pockets the premium.
The disadvantages of this strategy are as follows:
• there is a risk that the stock price may fall, resulting in an opportunity loss relative to the
outright sale of the stock.

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LM1 Options Strategies 2024 Level III Notes

• an opportunity loss also occurs if the stock rises sharply above the exercise price and is
sold at a lower-than-market price.
Profit and Loss at Expiration
The formulas in this subsection use the following terminology:
• S0 = Stock price when option position opened
• ST = Stock price at option expiration
• X = Option exercise price
• c0 = Call premium received or paid
The profit and loss relationships for a covered call strategy can be expressed as:
• Maximum gain = (X – S0) + c0
• Maximum loss = S0 – c0
• Breakeven point = S0 – c0
• Expiration value = ST – Max [(ST – X),0]
• Profit at expiration = ST – Max [(ST – X),0] + c0 – S0
Taking numbers from Exhibit A, currently S0 = 16.00, writing the IFT OCT 18 call for 1.00, X=
18.00, c0 = 1.00. If ST = 16.00 then:
• Max gain = 18 − 16 + 1 = 3
• Max loss = 16 − 1 = 15
• Breakeven point = 16 − 1 = 15
• Profit at expiration = 16 − 0 + 1 − 16 = 1 if ST = 16.00
Profit/loss diagram for the covered call

Example: Characteristics of Covered Calls

(This is Example 3 from the curriculum.)

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LM1 Options Strategies 2024 Level III Notes

S0 = Stock price when option position opened = 25.00

X = Option exercise price = 30.00
ST = Stock price at option expiration = 31.33
c0 = Call premium received = 1.55
1. Which of the following correctly calculates the maximum gain from writing a covered
call?
A. (ST – X) + c0 = 31.33 – 30.00 + 1.55 = 2.88
B. (ST – S0) – c0 = 31.33 – 25.00 –1.55 = 4.78
C. (X – S0) + c0 = 30.00 – 25.00 + 1.55 = 6.55
2. Which of the following correctly calculates the breakeven stock price from writing a
covered call?
A. S0 – c0 = 25.00 – 1.55 = 23.45
B. ST – c0 = 31.33 – 1.55 = 29.78
C. X + c0 = 30.00 + 1.55 = 31.55
3. Which of the following correctly calculates the maximum loss from writing a covered
call?
A. S0 – c0 = 25.00 – 1.55 = 23.45
B. ST – c0 = 31.33 – 1.55 = 29.78
C. ST – X + c0 = 31.33 – 30.00 + 1.55 = 2.88
Solution to 1:
C is correct. The covered call writer participates in gains up to the exercise price, after which
further appreciation is lost to the call buyer. That is, X – S0 = 30.00 – 25.00 = 5.00. The call
writer also keeps c0, the option premium, which is 1.55. So, the total maximum gain is 5.00 +
1.55 = 6.55.
Solution to 2:
A is correct. The call premium of 1.55 offsets a decline in the stock price by the amount of the
premium received: 25.00 – 1.55 = 23.45.
Solution to 3:
A is correct. The stock price can fall to zero, causing a loss of the entire investment, but the
option writer still keeps the option premium received: 25.00 – 1.55 = 23.45
4. Investment Objectives of Protective Puts
A protective put is a long position in a stock and a long position in a put option on that stock.
It is known as a protective put because the put provides protection against loss in value of
the underlying stock. Hence: Protective Put = Long Stock + Long Put.
Buying a put option is like buying insurance. The put premium is similar to insurance
premium. The exercise price of the put is similar to the coverage amount for an insurance

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LM1 Options Strategies 2024 Level III Notes

policy. Like traditional insurance, this insurance coverage also expires after a certain period
of time.
The investment objectives of protective puts are:
• Loss protection: Consider an investor who owns an IFT stock currently trading at 16.
His research suggests that there may be a negative shock to the stock price in the next
few weeks. To protect himself against a price decline the investor can purchase IFT
OCT 15 puts for $1.00. Thus, a protective put strategy will protect against losses
below 15 as long as the put does not expire before the occurrence of the expected
price shock.
• Upside preservation: Unlike a covered call strategy, a protective put strategy does
not limit the upside potential of the stock. If the stock price rises, the position fully
benefits from the appreciation, and the maximum gain is unlimited.
An important point to remember is that in a protective put, the put options provide coverage
for a certain period. After expiry, the investor has to purchase new put options for continued
coverage. If the investor continuously buys put options for protection, the amount spent on
the put premiums can significantly impact the return generated from the position. Therefore,
put options should be purchased selectively, only when an investor has a bearish outlook for
a short period.
Profit/loss diagram for protective put

Profit and Loss at Expiration

The profit and loss relationships of the protective put are given below:
• Maximum profit = ST – S0 – p0 = Unlimited
• Maximum loss = S0 – X + p0

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LM1 Options Strategies 2024 Level III Notes

• Breakeven point = S0 + p0
• Expiration value = Max(ST,X)
• Profit at expiration = Max(ST,X) – S0 – p0
Example: Characteristics of Protective Puts
(This is Example 4 from the curriculum.)
S0 = Stock price when option position opened = 25.00
X = Option exercise price = 20.00
ST = Stock price at option expiration = 31.33
p0 = Put premium paid = 1.15
1. Which of the following correctly calculates the gain with the protective put?
A. ST – S0 – p0 = 31.33 – 25.00 – 1.15 = 5.18
B. ST – S0 + p0 = 31.33 – 25.00 + 1.15 = 7.48
C. ST – X – p0 = 31.33 – 20.00 – 1.15 = 10.18
2. Which of the following correctly calculates the breakeven stock price with the protective
put?
A. S0 – p0 = 25.00 – 1.15 = 23.85
B. S0 + p0 = 25.00 + 1.15 = 26.15
C. ST + p0 = 31.33 + 1.15 = 32.48
3. Which of the following correctly calculates the maximum loss with the protective put?
A. S0 – X + p0 = 25.00 – 20.00 + 1.15 = 6.15
B. ST – X – p0 = 31.33 – 20.00 – 1.15 = 10.18
C. S0 – p0 = 25.00 – 1.15 = 23.85
Solution to 1:
A is correct. If the stock price is above the put exercise price at expiration, the put will expire
worthless. The profit is the gain on the stock (ST – S0) minus the cost of the put. Note that
the maximum profit with a protective put is theoretically unlimited, because the stock can
rise to any level and the entire profit is earned by the stockholder.
Solution to 2:
B is correct. Because the option buyer pays the put premium, she does not begin to make
money until the stock rises by enough to recover the premium paid.
Solution to 3:
A is correct. Once the stock falls to the put exercise price, further losses are eliminated. The
investor paid the option premium, so the total loss is the “deductible” plus the cost of the
insurance.
5. Equivalence to Long Asset/Short Forward Position
Delta measures the sensitivity of an option’s price to the underlying.

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LM1 Options Strategies 2024 Level III Notes

• Call deltas vary from 0 to 1. Delta of at-the-money call option ≈ 0.5.

• Put deltas vary from -1 to 0. Delta of at-the-money put option ≈ -0.5.
This is illustrated in Exhibit 12 of the curriculum.

By definition, the delta for a stock is 1 and the delta for a long position in a forward contract
is also 1.
The portfolio delta depends upon its constituents. For example,
• A portfolio comprising 100 shares will have a portfolio delta of 100 x 1 = 100.
• A portfolio comprising 100 shares and 100 at-the-money long call options on the
same stock will have a portfolio delta of 100 x 1 + 100 x 0.5 = 150
Covered call delta: If we construct a covered call portfolio with 100 shares and short 100
at-the-money call options, then the portfolio delta will be equal to 100 – 0.5 x 100 = 50
Protective put delta: Similarly, if we construct a protective put portfolio with 100 shares +
long 100 at-the-money put options, then the portfolio delta will be equal to 100 – 0.5 x 100 =
50
Long stock/short forward delta: If we construct a portfolio with 100 shares + short
forward position on 50 shares, then the portfolio delta will be equal to 100 – 50 x 1 = 50
These examples show three different positions: an ATM covered call, an ATM protective put,
and a long stock/short forward position that all have the same delta. For small changes in
the price of the underlying, these positions will provide similar payoffs.
Writing Puts
When someone writes a put option, he has an obligation to buy the underlying stock at the
exercise price.
A cash-secured put is when an investor sells a put option and deposits an amount of money
equal to the exercise price into a designated account. The cash in a cash-secured put is
similar to a stock in a covered call strategy. The cash-secured put strategy is appropriate
when an investor is bullish on a stock or wants to acquire shares at a particular price.
Scenario: IFT stock is currently at 16.00. An investor wants to purchase the stock for 15.00.
To do so, the investor writes the SEP 15 put for 0.65 (Exhibit A). If the stock is above 15 at
expiration the put option will expire worthless and the investor pockets the put premium. If

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LM1 Options Strategies 2024 Level III Notes

the stock is below 15 at expiration, the put will be exercised and the option writer will
purchase shares at an effective purchase price (= exercise price – put premium = 15 – 0.65)
of 14.35.

6. Risk Reduction Using Covered Calls and Protective Puts

Covered calls and protective puts are both risk-reducing strategies.
Covered calls: Say an investor purchases a stock at 25. If the price goes down to 20, the
investor will incur a loss of 5. To hedge this risk the investor sells a call option with a strike
price of 25. Assume that the premium received from selling this option is 3. Now, if the stock
price goes down to 25, the call premium will help offset some of the loss and the investor
will incur a net loss of 2. Therefore, a covered call strategy provides some downside cushion.
But this cushion comes at a price, the call writer has to give up the potential upside of the
stock.
The delta for a long stock position is 1. However, the delta for a covered call position, i.e. long
stock + short call = 1 – 0.5 = 0.5. A lower delta indicates reduced sensitivity to changes in
stock price and therefore lower risk.
Protective puts: With a protective put, the put option provides downside protection. But
this protection is at a cost because the put buyer must pay the option premium. Say an
investor owns a stock currently at 25, and he buys an at-the-money put option for 2. If the
stock price goes down to 20, the investor will receive a gain of 5 from the put option and his
net loss will be 2 (the put premium). However, continually buying puts in anticipation of a
stock price decline will wipe out long-term gains on the stock.
The delta for a long stock position is 1. However, the delta for a protective put position, i.e.
long stock + long put = 1 – 0.5 = 0.5. The lower delta indicates lower risk.
Buying calls on a short position: If an investor goes short on a stock, he is exposed to the
risk that the stock price may go up. To hedge this risk the investor can purchase a call option.
If the stock price goes up, the loss from the short position will be offset by the gains on the
long call.
Writing puts on a short position: The risk in a short position can also be hedged by writing
put options. If the stock price goes up, the put will expire worthless but the put premium
that the investor received will help cushion some of the loss of the short stock position.
Example: Risk-Reduction Strategies
(This is Example 5 from the curriculum.)
Janet Reiter is a US-based investor who holds a limited partnership investment in a French
private equity firm. She has received notice from the firm’s general partner of an upcoming
capital call. Reiter plans to purchase €1,000,000 in three months to meet the capital call due
at that time. The current exchange rate is US$1.20/€1, but Reiter is concerned the euro will
strengthen against the US dollar. She considers the following instruments to reduce the risk

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LM1 Options Strategies 2024 Level III Notes

of the planned purchase:

• A three-month USD/EUR call option (to buy euros) with a strike rate X = US$1.25/€1 and
costing US$0.02/€1
• A three-month EUR/USD put option (to sell dollars) with a strike rate X = €0.8080/US$1
priced at €0.0134/US$1
• A three-month USD/EUR futures contract (to buy euros) with f0 = US$1.2052/€1
1. Discuss the position required in each instrument to reduce the risk of the planned
purchase.
2. Reiter purchases call options for US$20,000, and the exchange rate increases to
US$1.29/€1 (EUR currency strengthens) over the next three months. The effective price
Reiter pays for her 1,000,000 EUR purchase is closest to:
A. US$1,270,000.
B. US$1,290,000.
C. US$1,310,000.
3. Calculate the price Reiter will pay for the EUR using the three instruments if the
exchange rate in three months falls to US$1.10/€1 (EUR currency weakens).
Solution to 1:
Reiter could purchase a €1,000,000 call option struck at US$1.25/€1 for US$20,000. If the
EUR price were to increase above US$1.25, she would exercise her right to buy EUR for
US$1.25. She would also benefit from being able to purchase EUR at a cheaper price should
the exchange rate weaken. A call on the euro is like a put on the US dollar. So, a put to sell
dollars struck at an exchange rate of X = €0.8000/US$1 can be viewed as a call to buy Euro at
an exchange rate of US$1/€0.8000 = US$1.25/€1. Reiter could also buy a put option on USD
struck at X = €0.8080/US$1 which would allow her to sell US$1,237,624 (=
€1,000,000/[€0.8080/$1]) to receive the €1,000,000 should the dollar weaken below that
level. This would cost her €0.0134/US$1 × US$1,237,624 = €16,584 or US$19,901 upfront. If
USD appreciated against the EUR, Reiter would still be able to benefit from the lower cost to
purchase the EUR. She could instead enter a long position in a three-month futures contract
at US$1.2052. Reiter would have the obligation to purchase €1,000,000 at US$1.2052
regardless of the exchange rate in three months. The futures position requires a margin
deposit, but no premium is paid.
Solution to 2:
A is correct. At an exchange rate of US$1.29/€1, the call with strike of X = US$1.25/€1 will be
exercised. Including the call premium (US$0.02/€1), the price effectively paid for the euros
is US$1.27/€1 × €1,000,000 = US$1,270,000.
Solution to 3:
Both the call and the put options will expire unexercised and Reiter benefits from the lower

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LM1 Options Strategies 2024 Level III Notes

rate by purchasing €1,000,000 for US$1,100,000. However, she will lose the premiums she
paid for the options. For the futures contract, she pays US$1.2052/€1 or US$1,205,200 for
€1,000,000 regardless of the more favorable rate.
7. Spreads and Combinations
An option spread is a strategy that involves two options of the same type which differ by
exercise price only. The term spread means the payoff is based on the difference, or spread,
between option exercise prices. For a bull or bear spread, the investor buys a call and writes
another call with a different exercise price or buys a put and writes another put with a
different exercise price. An option combination uses both types of options, for example, an
investor buys a call option and sells a put option.
Bull Spreads and Bear Spreads
Bull and bear spreads represent cost-effective bets on the direction of the underlying. A bull
spread increases in value when the underlying rises. A bear spread increases in value when
the underlying falls.
If a cash payment is required to establish a spread, then it is a debit spread. If a cash
payment is received as a result of the spread, then the spread is called a credit spread.
Spreads can be established with call options or with put options. For simplicity purposes, we
will use call options to construct bull spreads and put options for bear spreads.
Bull Spread
Investment objective: To benefit from an increase in price of the underlying while keeping
costs low.
Structure: Buy one call option with a lower exercise price and sell another with a higher
exercise price.
Scenario: Say the IFT stock is trading at $16 in August. If an investor believes that the stock
will not rise above $18 in two months, he can use an OCT 16/18 bull call spread strategy. It
will involve the following:
• buy the OCT 16 call option for 2.00
• sell the OCT 18 call option for 1.00
The cost, breakeven stock price, and the maximum profit for bull spread are given by:
• Cost = cL – cH
• Maximum profit = XH – XL – cost
• Breakeven price for a call bull spread = XL + cost
where:
XL = the lower exercise price, XH = the higher exercise price
cL = call with the lower-strike price, cH = call with the higher-strike price

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Using the data given above, the net cost is 2.00 – 1.00 = 1.00
Breakeven price = 16 + 1 = 17.
Maximum profit = 18 – 16 – 1 = 1.
The payoff diagram for this strategy is:

The profit diagram for this strategy can be constructed by shifting the payoff diagram down
by 1 which is the cost of the strategy.

The maximum profit occurs at or above the exercise price of 18.

Notice that by buying the OCT 16 call option the investor benefits if his bullish outlook is
correct and the stock price increases. The bull spread strategy is cost-effective because the

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LM1 Options Strategies 2024 Level III Notes

cost of the OCT 16 is partially offset by selling the OCT 18 option.

The risk of this strategy is that the investor will make a loss if the stock price stays below 17.
Also, gains above 18 are given up in exchange for a lower cost of this position.
Bear Spread
Investment objective: To benefit from a decrease in price of the underlying while keeping
cost low.
Structure: Buy one put option with a higher exercise price and sell another with a lower
exercise price.
Scenario: Say the IFT stock is trading at $16 in August. If an investor believes that the stock
will decline to 14 by October, he can establish an OCT 14/16 bear spread to benefit from this
outlook. To do this, he can:
• buy the IFT OCT 16 put for 2.00
• sell the IFT OCT 14 put for 1.00
The cost, breakeven stock price, and the maximum profit for bear spread are given by:
• Cost = pH – pL
• Maximum profit = XH – XL – cost
• Breakeven price for a put bear spread = XH - cost
where,
XL = the lower exercise price, XH = the higher exercise price
pL = the lower-strike price put, pH = the higher-strike price put
Using the data given above, the net cost of the spread = 2.00 - 1.00 = 1.00
Breakeven price = 16 – 1 = 15.
Maximum profit = 16 – 14 – 1 = 1.
The payoff diagram for this strategy is:

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LM1 Options Strategies 2024 Level III Notes

The profit diagram for this strategy can be constructed by shifting the payoff diagram down
by 1 which is the cost of the strategy.

The maximum profit occurs at or below the exercise price of 14.

Notice that the investor benefits by establishing the OCT 14/16 bear spread if his bearish
outlook is correct and the stock price declines. The bear spread strategy is cost-effective
because the cost of the OCT 16 put is partially offset by selling the OCT 14 put.
The risk of the strategy is that the investor will make a loss if the stock price stays above 15.
Gains below the stock price of 14 are given up for reducing the cost of this position.
Example: Spreads
(This is Example 6 from the curriculum.)
Use the following information to answer questions 1 to 3 on spreads.
S0 = 44.50
OCT 45 call = 2.55, OCT 45 put = 2.92
OCT 50 call = 1.45, OCT 50 put = 6.80
1. What is the maximum gain with an OCT 45/50 bull call spread?
A. 1.10
B. 3.05
C. 3.90
2. What is the maximum loss with an OCT 45/50 bear put spread?
A. 1.12
B. 3.88
C. 4.38

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LM1 Options Strategies 2024 Level III Notes

3. What is the breakeven price with an OCT 45/50 bull call spread?
A. 46.10
B. 47.50
C. 48.88
Solution to 1:
C is correct. With a bull spread, the maximum gain occurs at the high exercise price. At an
underlying price of 50 or higher, the spread is worth the difference in the strike prices, or 50
– 45 = 5. The cost of establishing the spread is the price paid for the lower-strike option
minus the price received for the higher-strike option: 2.55 – 1.45 = 1.10. The maximum gain
is 5.00 – 1.10 = 3.90.
Solution to 2:
B is correct. With a bear spread, an investor buys the higher exercise price and writes the
lower exercise price. When this strategy is done with puts, the higher exercise price option
costs more than the lower exercise price option. Thus, the investor has a debit spread with
an initial cash outlay, which is the most he can lose. The initial cash outlay is the cost of the
OCT 50 put minus the premium received from writing the OCT 45 put: 6.80 – 2.92 = 3.88.
Solution to 3:
A is correct. An investor buys the OCT 45 call for 2.55 and sells the OCT 50 call for 1.45, for a
net cost of 1.10. She breaks even when the position is worth the price she paid. The long call
is worth 1.10 at a stock price of 46.10, and the OCT 50 call will expire out of the money and
thus be worthless. The breakeven price is the lower exercise price of 45 plus the 1.10 cost of
the spread, or 46.10.
Refining spreads: It is not necessary that both legs of the spread be established at the same
time or maintained for the same period. Based on market conditions, spreads can be
adjusted to capitalize on price movement and increase profits.

8. Straddle
Investment objective: To take advantage of an (a) increase (decrease) in volatility.
Structure: A long straddle is created by buying a call and a put. The call and put should be on
the same underlying asset. The exercise price of the call and put should be the same. The
party that writes (sells) the call and put options takes a short straddle position.
A straddle is a directional play on the volatility of the underlying. A long straddle has a
positive payoff if the true (actual) volatility of the underlying is higher than the expected
volatility (predicted by the market participants). A short straddle has a positive payoff if the
actual volatility of the underlying is less than the expected volatility.
Assume a stock sells for 50, and the straddle buyer invests in 30-day options with an
exercise price of 50. The call price is 3 and the put price is 2, for a total cost of 5. For the

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LM1 Options Strategies 2024 Level III Notes

straddle to be profitable, one of these two options must be profitable enough to recover the
costs of both the put and call.
The payoff and profit diagram of this long straddle strategy is:

The profit diagram is obtained by shifting the payoff down by 5 which is the cost of the
strategy.
The cost, max profit, breakeven and max loss of a long straddle are given by:
• Cost = c0 + p0
• Max profit = unlimited
• Breakeven = X + cost, X – cost (As can be seen in the profit diagram, a straddle has
two breakeven points)
• Max loss = cost
The risk of a long straddle is limited to the amount paid for the two option positions. The
movement in stock price, therefore, needs to be higher than the combined cost of the two
options for the position to be profitable. If an investor believes that the stock price
movement will not be significant to recover the cost of the combined option premiums, he or
she may write the options instead and take a short straddle position.
The Greeks for a straddle are shown in Exhibit 22.

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LM1 Options Strategies 2024 Level III Notes

The long straddle initially has a very low delta (+0.069 for this example) with a high gamma
(0.139). The portfolio is not very sensitive to initial small changes in the stock price, but this
sensitivity increases quickly once the stock starts moving in a particular direction.
The vega for the long straddle is +0.114, meaning the portfolio will profit by approximately
0.114 from increased volatility of 1% in the underlying.
Collars
Investment objective: To limit downside risk at a low cost
Structure: A collar involves long shares of stock, a long put with an exercise price below the
current stock price, and a short call with an exercise price above the current stock price.
Collars:
• provide downside protection through a put
• reduce the cash outlay by writing a call
Scenario: An investor previously bought a stock of XYZ company at $12. He now buys the
NOV 15 put for 1.46 and simultaneously writes the NOV 17 call for 1.44. Exhibit 24 shows
the profit and loss diagram for this collar.

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LM1 Options Strategies 2024 Level III Notes

As shown in the diagram, the position has a minimum gain of at least 2.98. This is because
the stock price had appreciated before establishing the collar. Investors typically establish a
collar on a position that is already outstanding.
The cost, max profit, and min profit of the strategy are given by:
• Cost = S0 + p0 – c0
• Max profit = X2 – cost
• Min profit = X1 – cost
A collar forgoes the positive part of the return distribution in exchange for the removal of the
adverse portion. The investor sells the right side of the return distribution by writing a call
but receives protection against the left side of the distribution and losses by buying a put.
The investment outcomes narrow, which is risk reducing, in exchange for limited return.
Calendar Spread
Investment objective: To take advantage of time decay.
There are two types of calendar spreads:
• Short calendar spread requires selling a longer-dated call and buying a near-term
call. This strategy is profitable when greater price movements are expected in the
near-term relative to price movements in the future.
• Long calendar spread requires selling a near-dated call and buying a long-dated call.
This strategy is profitable when investment outlook is flat in the near-term, but
greater price movements are expected in the future.
Instructor’s Note:
Calendar spreads can also be constructed using put options.
Scenario: Suppose XYZ stock is trading at 45 in August. A trader believes that the stock will
be stable at the current level for the year but will rise by early next year. He has access to
options shown below (taken from the curriculum):
Calendar Spread Call Option Prices (August)
Exercise Price SEP OCT JAN
40 5.15 5.47 6.63
45 1.55 2.19 3.81
50 0.22 0.62 1.99
Based on his outlook on the stock, the trader executes a long calendar spread strategy. He
buys XYZ JAN 45 call for 3.81 and sells XYZ SEP 45 call for 1.55. The net cost is 3.81 – 1.55 =
2.26.

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LM1 Options Strategies 2024 Level III Notes

Assume that when the SEP 45 option expires, XYZ stock is at 45 and when the JAN 45 option
expires the stock is at 50. In this case, the SEP 45 call is worthless, but the JAN 45 option is in
the money.
In this example, the long calendar spread trader takes advantage of time decay. Time decay
is more pronounced for a short-term option than for a long-term one. The long calendar
spread trader exploits this by purchasing a longer-term option and writing a shorter-term
option.

9. Implied Volatility and Volatility Skew

Implied volatility: Implied volatility can be derived from the Black-Scholes-Merton (BSM)
option pricing model. The inputs to the BSM model are the option’s strike price, the price of
the underlying, the time to option expiration, the risk-free interest rate, and volatility of the
underlying. All inputs expect volatility are observable. The output is the option price. Implied
volatility is a value that equates the model price of an option to its market price. All else
equal, a higher option market price implies higher volatility and vice versa.
Realized volatility: Realized volatility is the actual historical volatility of the underlying
over a given time period. For example, for a given stock we can calculate the daily returns
over the last one month. This data can be used to calculate the monthly standard deviation
σM. The monthly standard deviation can be annualized by using the following formula:
σA = σM × √12
Volatility smile and skew: The implied volatility is a function of the strike price. Exhibit 28
from the curriculum plots implied volatility (y-axis) against strike price (x-axis) for options
on the same underlying with the same expiration.

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LM1 Options Strategies 2024 Level III Notes

• The underlying is trading at 19,000. Options with a strike price of 19.000 are ATM
options. Call options with strike prices higher than 19,000 are OTM. Similarly, put
options with strike prices lower than 19,000 are OTM.
• If the implied volatilities of both OTM puts and OTM calls are higher than the implied
volatilities of ATM options, the curve is U-shaped and is called a volatility smile
(since it resembles the shape of a smile.)
• However, the more common shape of the implied volatility curve is a volatility skew
where the implied volatility increases for OTM puts and decreases for OTM calls, as
the strike price moves away from the current price.
The extent of the skew depends on the following factors:
• Supply/demand: When investors are looking to hedge the underlying asset, the
demand for put options exceeds that for call options. The excess demand for put
options relative to the demand for call options, increases the put prices and their
implied volatilities. This demand/supply imbalance will increase the degree of the
skew.
• Investor sentiment: If investor sentiment becomes bearish, the demand for put
options will go up raising their implied volatilities and therefore the skew will
increase.
Measuring volatility skew: Exhibit 29 from the curriculum shows the levels of implied
volatility at different degrees of moneyness for options on a few equity indexes. The 90%
moneyness option is a put with strike (X) equal to 90% of the current underlying price (S);
thus X/S = 90%. Similarly, the 110% moneyness option is a call option with strike (X), where
X/S = 110%. The skew is calculated as the difference between the implied volatilities of the
90% put and the 110% call.

Risk reversal strategy: If a trader believes that the current skew in the volatility curve is
too high and expects the skew to reduce in the future, he can take a long position in a risk
reversal strategy. He will buy OTM calls and sell the same expiration OTM puts. This options
position is then delta-hedged by selling the underlying asset.
This strategy will be profitable if the implied volatility of OTM calls rises more relative to the
implied volatility of OTM puts. In other words, if the investor view is correct the volatility
skew decreases.

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LM1 Options Strategies 2024 Level III Notes

Term structure of volatility: Typically, for the same underlying and strike price, the
implied volatilities of options with longer maturities are higher than the implied volatilities
of options with shorter maturities. Therefore, the term structure of volatility is often in
contango.
Implied volatility surface: It can be thought of as a 3D plot, for options on the same
underlying asset, with days to expiration, option strike prices, and implied volatilities on the
X, Y, and Z axis respectively. It simultaneously shows the volatility skew and the term
structure of implied volatility.
10. Investment Objectives and Strategy Selection
The Necessity of Setting an Objective
Derivatives should be used to achieve a well-defined investment objective. Three high-level
objectives include:
1. Hedging
2. Taking directional bets
3. Arbitrage
Factors to consider when setting objectives include:
• Actual portfolio – For example, when using derivatives for hedging, we need to
consider the characteristics of the actual portfolio being hedged.
• Market outlook – This includes views on both direction and volatility.
• Timeframe – The time period required to execute the strategy.
• Benefits/limitations of derivatives – For example, close attention should be given to
Greeks, as they provide insights on how option prices may change.
Criteria for Identifying Appropriate Option Strategies
Option strategies are often based on the outlook on direction and volatility of the underlying
asset. Exhibit 32 of the curriculum outlines the appropriate strategy under different market
conditions.
Outlook on the Trend of Underlying Asset
Trading Range/
Bearish Bullish
Neutral View
Decrease Write calls Write straddle Write puts
Expected
Move in Remain Write calls and Calendar spread Buy calls and
Implied Unchanged buy puts write puts
Volatility
Increase Buy puts Buy straddle Buy calls

Few points to note:

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LM1 Options Strategies 2024 Level III Notes

• In general, if we expect volatility to decrease, we should write options. Whereas, if we

expect volatility to increase, we should buy options.
• In general, if we expect the underlying price to go up, we should buy call options.
Whereas, if we expect the underlying price to go down, then we should buy put
options.
The following table provides a few sample scenarios and the appropriate strategies for these
scenarios.
Objective/Outlook Strategy
Buy stock only if price falls below target price Sell puts with X = target price
Benefit from moderate increase in stock price Bull spread
Implied volatility will rise in given timeframe Long straddle
Long-term bearish and near-term neutral outlook Long calendar spread

11. Uses of Options in Portfolio Management

This section includes mini cases that discuss ways in which different investors use
derivatives to solve a particular situation. Only the most important facts from each case are
presented here. To get a complete understanding of these cases please refer to the
curriculum.
Covered Call Writing
Case facts: Carlos Rivera’s client needs to raise $30,000 relatively quickly for the wedding
expenses of her daughter. Client is “asset rich and cash poor.” Revised investment policy
statement permits all option activity except the writing of naked calls. Portfolio account has
5,000 shares of Manzana (MNZA) stock, which she is planning to sell in the near-term. Rivera
has a bearish outlook on this stock. Exhibit 33 contains call and put price information for
May MNZA options with strike prices close to the current market price of MNZA shares (S0 =
$169)

Strategy: To generate cash, Rivera should use the covered call strategy. Call options with the
170-strike price should be sold. This will generate cash of 5,000 x 6.45 = 32,250, sufficient
for the client’s requirement.

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LM1 Options Strategies 2024 Level III Notes

The risks of this strategy are:

• The stock price increases above 170 and the options are exercised. Also, any upside
potential above 170 is lost.
• If Rivera’s bearish outlook is correct, the shares may drop in value resulting in a loss
on the long stock position.
Put Writing
Case facts: Oscar Quintera wants to purchase 50,000 MNZA shares, but not at the current
price of 169. Oscar wants to buy the shares at 165 or lower. He decides to write OTM puts on
MNZA shares. The put premium is 5.30.
Discuss the outcome of this strategy for two scenarios:
• Scenario A: The stock price is 163 on the option expiration day.
• Scenario B: The stock price is 177 on the option expiration day.
Solution:
Scenario A: At 163 the put option will be exercised. Oscar will buy shares at 165 which is his
objective. Also, the put premium will reduce his effective purchase price to 165 – 5.30 =
159.70, improving on the market price of 163.
Scenario B: At 177, the put option will expire worthless. Oscar will not buy the shares, but he
will pocket the premium of 5.30 per share.
Long Straddle
Case facts: Katrina Hamlet has been following Manzana stock for the past year. She
anticipates the announcement of a major new product soon, but she is not sure how the
critics will react to it. If the new product is praised, she believes the stock price will increase
dramatically. If the product does not impress, she believes the share price will fall
substantially. Hamlet has been considering trading around the event with a straddle. The
stock is currently priced at $169.00, and she is focused on close-to-the-money (170) calls
and puts selling for 6.45 and 7.69, respectively.
Hamlet expects that the stock will move at least 10% either way once the product
announcement is made, making the straddle strategy potentially appropriate.
After the market close, Hamlet hears a news story indicating that the product will be
unveiled at a trade show in two weeks. The following morning after the market opens, she
goes to place her trade and finds that although the stock price remains at $169.00, the option
prices have adjusted upward to $10.20 for the call and $10.89 for the put.
Discuss whether the new option premiums have any implications for Hamlet’s intended
straddle strategy.

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LM1 Options Strategies 2024 Level III Notes

Solution:

In her earlier planning, the break-even points were 155.86 and 184.14 which would have
made the strategy profitable since she was expecting a change of 169 ± 10%. However, the
new breakeven points require the stock to move by 12% to be profitable. Hence, she should
not execute this straddle trade.
Example: Straddle Analytics
(This is Example 7 from the curriculum.)
Use the following information to answer Questions 1 to 3 on straddles.
XYZ stock price = 100.00
100-strike call premium = 8.00
100-strike put premium = 7.50
Options expire in three months
1. If Yelena Strelnikov, a portfolio manager, buys a straddle on XYZ stock, she is best
described as expecting a:
A. higher volatility market.
B. lower volatility market.
C. stable volatility market.
2. This strategy will break even at expiration stock prices of:
A. 92.50 and 108.50.
B. 92.00 and 108.00.
C. 84.50 and 115.50.
3. Reaching an upside breakeven point implies an annualized rate of return on XYZ stock
closest to:

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LM1 Options Strategies 2024 Level III Notes

A. 16%.
B. 31%.
C. 62%.
Solution to 1:
A is correct. A straddle is directionally neutral in terms of price; it is neither bullish nor
bearish. The straddle buyer wants higher volatility and wants it quickly but does not care in
which direction the price of the underlying moves. The worst outcome is for the underlying
asset to remain stable.
Solution to 2:
C is correct. To break even, the stock price must move enough to recover the cost of both the
put and the call. These premiums total to $15.50, so the stock must move up at least to
$115.50 or down to $84.50.
Solution to 3:
C is correct. The price change to a breakeven point is 15.50 points, or 15.5% on a 100 stock.
This is for three months. Ignoring compounding, this outcome is equivalent to an annualized
rate of 62% on XYZ stock, found by multiplying by 12/3 (15.5% × 4 = 62%).
Collar
Case facts: Bernhard Steinbacher has a client with a holding of 100,000 shares in Tundra
Corporation, currently trading for €14 per share. The client has owned the shares for many
years and thus has a very low tax basis on this stock. Steinbacher wants to safeguard the
position’s value because the client does not want to sell the shares. He does not find
exchange-traded options on the stock. Steinbacher wants to present a way in which the
client could protect the investment portfolio from a decline in Tundra’s stock price.
Discuss an option strategy that Steinbacher might recommend to his client.
Solution: In the over-the-counter market, Steinbacher might buy a put and then write an
out-of-the money call. This strategy is a collar. The put provides downside protection below
the put exercise price, and the call generates income to help offset the cost of the put.
Calendar Spread
Case facts: Ivanka Dubois is a professional advisor to high-net-worth investors. She expects
little price movement in the Euro Stoxx 50 in the next three months but has a bearish long-
term outlook. The consensus sentiment favoring a flat market shows no signs of changing
over the next few months, and the Euro Stoxx 50 is currently trading at 3500. Exhibit 37
shows prices for two put options with a strike price of 3500 that are available on the index.
Both options have the same implied volatility.

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LM1 Options Strategies 2024 Level III Notes

Discuss how can Dubois take advantage of her out-of-consensus view.

Solution: Dubois can implement a put calendar spread trade by selling the three-month put
option (A) for €119 and buying the six-month same strike put option (B) at the price of
€173. Therefore, the cost of establishing this strategy is a net debit of €54 per contact (given
by €173 − €119).
12. Hedging an Expected Increase in Equity Market Volatility
Case facts: Jack Wu is a fund manager who oversees a stock portfolio valued at US$50
million that is benchmarked to the S&P 500. He expects an imminent significant correction in
the US stock market and wants to profit from an anticipated jump in short-term volatility.
VIX is a measure of expected future volatility. The VIX Index is currently at 14.87 and Exhibit
40 shows quotes for options on VIX.

Discuss a strategy that Wu can implement.

Solution: Wu can purchase the 15.60 call on the VIX and, to partially finance the purchase,
he can sell an equal number of the 14.75 VIX puts. The total cost of the options strategy is
0.45 (= 2.00 – 1.55) per contract.
At expiry, the strategy will be profitable if volatility spikes up (as anticipated) and the VIX
futures increase above 16.05. This is calculated as the call strike of 15.60 plus the net cost of
the options (15.60 + 0.45). Above this level, the strategy will gain proportionally. In contrast,
Wu’s option strategy will lose proportionally to its exposure to the short puts if the VIX
futures’ settlement price is below 14.75 (put strike).
Establishing or Modifying Equity Risk Exposure
Long Call
Case facts: Armando Sanchez is a private wealth advisor working in London. He expects the
shares of Markle Co. Ltd. will move from the current price of £60 a share to £70 a share over
the next three months. He wants to use call options to benefit from this view. Prices for
three-month call options on the stock are shown in Exhibit 42. Determine which option will
be the most profitable.

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LM1 Options Strategies 2024 Level III Notes

Solution: Option C is not appropriate, because it has a strike price of 70. If the stock reaches
70, there will be no payoff from the option.
The expected payoff from option B is 70 – 60 = 10. The profit is 10 – 3 = 7. The profitability is
7/3 = 2.3
The expected payoff from option A is 70 – 58 = 12. The profit is 12 – 4 = 8. The profitability is
8/4 = 2
Therefore, Option B is the most profitable.
Protective Put Position
Case facts: Eliot McLaire manages a Glasgow-based hedge fund that holds 100,000 shares of
Relais Corporation, currently trading at €42.00. He is concerned that the stock price will go
down by 10% to 37.80. Exhibit 43 provides information on options prices for Relais
Corporation.

Determine which option will be the most profitable.

Solution:
The expected payoff from Option A is 40 – 37.80 = 2.2. The profit is 2.2 – 1.45 = 0.75. The
profitability is 0.75/1.45 = 0.5
The expected payoff from Option B is 42.50 – 37.80 = 4.7. The profit is 4.7 – 1.72 = 2.98. The
profitability is 2.98/1.72 = 1.7
The expected payoff from Option C is 45 – 37.80 = 7.2. The profit is 7.2 – 3.46 = 3.74. The
profitability is 3.74 / 3.46 = 1.1
Therefore, Option B is the most profitable.

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LM1 Options Strategies 2024 Level III Notes

Summary
LO: Demonstrate how an asset’s returns may be replicated by using options.
Buying a call and writing a put on the same underlying with the same strike price and
expiration creates a synthetic long position (or, a synthetic long forward position).
Selling a call and buying a put on the same underlying with the same strike price and
expiration creates a synthetic short position.
A synthetic long put position consists of a short stock and long call position in which the call
strike price equals the price at which the stock is shorted.
A synthetic long call position consists of a long stock and long put position in which the put
strike price equals the price at which the stock is purchased.
LO: Discuss the investment objective(s), structure, payoff, risk(s), value at expiration,
profit, maximum profit, maximum loss, and breakeven underlying price at expiration
of a covered call position.
Covered Call = Long Stock + Short Call.
The investment objectives of covered calls are:
• Yield enhancement
• Reducing position at a favorable price
• Target price realization
The profit and loss relationships for a covered call strategy can be expressed as:
• Maximum gain = (X – S0) + c0
• Maximum loss = S0 – c0
• Breakeven point = S0 – c0
• Expiration value = ST – Max [(ST – X),0]
• Profit at expiration = ST – Max [(ST – X),0] + c0 – S0
LO: Discuss the investment objective(s), structure, payoff, risk(s), value at expiration,
profit, maximum profit, maximum loss, and breakeven underlying price at expiration
of a protective put position.
Protective Put = Long Stock + Long Put
The investment objectives of protective puts are:
• Loss protection
• Upside preservation
The profit and loss relationships of the protective put are given below:
• Maximum profit = ST – S0 – p0 = Unlimited
• Maximum loss = S0 – X + p0
• Breakeven point = S0 + p0

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LM1 Options Strategies 2024 Level III Notes

• Expiration value = Max(ST,X)

• Profit at expiration = Max(ST,X) – S0 – p0
LO: Compare the delta of covered call and protective put positions with the position of
being long an asset and short a forward on the underlying asset.
Covered call delta: If we construct a covered call portfolio with 100 shares – 100 at-the-
money call options, then the delta of this portfolio will be equal to 100 – 0.5 x 100 = 50
Protective put delta: Similarly, if we construct a protective put portfolio with 100 shares +
long 100 at-the-money put options, then the delta of this portfolio will be equal to 100 – 0.5 x
100 = 50
Long stock/short forward delta: If we construct a portfolio with 100 shares + short forward
position on 50 shares, then the portfolio delta will be equal to 100 – 50 x 1 = 50
These examples show three different positions: an ATM covered call, an ATM protective put,
and a long stock/short forward position have the same delta. For small changes in the price
of the underlying, these positions will provide similar payoffs.
LO: Compare the effect of buying a call on a short underlying position with the effect of
selling a put on a short underlying position.
Buying calls on a short position: If an investor goes short on a stock, he is exposed to the risk
that the stock price may go up. To hedge this risk the investor can purchase a call option. If
the stock price goes up, the loss from the short position will be offset by the gains on the long
call.
Writing puts on a short position: The risk in a short position can also be hedged by writing
put options. If the stock price goes up, the put will expire worthless but the put premium
that the investor received will help cushion some of the loss.
LO: Discuss the investment objective(s), structure, payoffs, risk(s), value at expiration,
profit, maximum profit, maximum loss, and breakeven underlying price at expiration
of the following option strategies: bull spread, bear spread, straddle, and collar.
Bull Spread
Investment objective: To benefit from an increase in price of the underlying while keeping
costs low.
Structure: Buy a call option with a low exercise price and sell a call option with a high
exercise price.
The cost, breakeven stock price, and the maximum profit for bull spread are given by:
• Cost = cL – cH
• Maximum profit = XH – XL – cost
• Breakeven price for a call bull spread = XL + cost

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LM1 Options Strategies 2024 Level III Notes

Bear Spread
Investment objective: To benefit from a decrease in price of the underlying while keeping
cost low.
Structure: Buy a put option with a high exercise price and sell a put option with a low
exercise price.
The cost, breakeven stock price, and the maximum profit for bear spread are given by:
• Cost = pH – pL
• Maximum profit = XH – XL – cost
• Breakeven price for a put bear spread = XH - cost
Straddle
Investment objective: To take advantage of volatility.
Structure: A long straddle is created by buying a call and buying a put. The call and put
should be on the same underlying asset. The exercise price of the call and put should be the
same.
The cost, max profit, breakeven and max loss of a long straddle are given by:
• Cost = c0 + p0
• Max profit = unlimited
• Breakeven = X + cost, X – cost (As seen in the profit diagram, a straddle has two
breakeven points)
• Max loss = cost
Collars
Investment objective: To limit downside risk at a low cost
Structure: A collar consists of long shares of stock, a long put with an exercise price below
the current stock price, and short call with an exercise price above the current stock price.
The cost, max profit, and min profit of the strategy are given by:
• Cost = S0 + p0 – c0
• Max profit = X2 – cost
• Min profit = X1 – cost
LO: Describe uses of calendar spreads.
Calendar spreads are used to take advantage of time decay when volatility is expected to
change.
There are two types of calendar spreads:

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LM1 Options Strategies 2024 Level III Notes

• Short calendar spread: selling a longer-dated call, buying a near-term option. This
strategy is profitable when greater price movements are expected in the near-term
relative to price movements expected in the future.
• Long calendar spread: selling a near-dated call, buying a long-dated call. This strategy
is profitable when investment outlook is flat in the near term, but greater price
movements are expected in the future.
LO: Discuss volatility skew and smile.

• If the implied volatilities of both OTM puts and OTM calls are higher than the implied
volatilities of ATM options, the curve is U-shaped and is called a volatility smile
(since it resembles the shape of a smile.)
• However, the more common shape of a volatility curve is a volatility skew where the
implied volatility increases for OTM puts and decreases for OTM calls, as the strike
price moves away from the current price.
LO: Identify and evaluate appropriate option strategies consistent with given
investment objectives.
Outlook on the Trend of Underlying Asset
Trading Range/
Bearish Bullish
Neutral View
Decrease Write calls Write straddle Write puts
Expected
Move in Remain Write calls and Calendar spread Buy calls and
Implied Unchanged buy puts write puts
Volatility
Increase Buy puts Buy straddle Buy calls
LO: Demonstrate the use of options to achieve targeted equity risk exposures.
Long Call

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LM1 Options Strategies 2024 Level III Notes

Case facts: Armando Sanchez is a private wealth advisor working in London. He expects the
shares of Markle Co. Ltd. will move from the current price of £60 a share to £70 a share over
the next three months. He wants to use call options to benefit from this view. Prices for
three-month call options on the stock are shown in Exhibit 42. Determine which option will
be the most profitable.

Solution: Option C is not appropriate, because it has a strike price of 70. If the stock reaches
70, there will be no payoff from the option.
The expected payoff from option B is 70 – 60 = 10. The profit is 10 – 3 = 7. The profitability is
7/3 = 2.3
The expected payoff from option A is 70 – 58 = 12. The profit is 12 – 4 = 8. The profitability is
8/4 = 2
Therefore, Option B is the most profitable.
Protective Put Position
Case facts: Eliot McLaire manages a Glasgow-based hedge fund that holds 100,000 shares of
Relais Corporation, currently trading at €42.00. He is concerned that the stock price will go
down by 10% to 37.80. Exhibit 43 provides information on options prices for Relais
Corporation.

Determine which option will be the most profitable.

Solution:
The expected payoff from Option A is 40 – 37.80 = 2.2. The profit is 2.2 – 1.45 = 0.75. The
profitability is 0.75/1.45 = 0.5
The expected payoff from Option B is 42.50 – 37.80 = 4.7. The profit is 4.7 – 1.72 = 2.98. The
profitability is 2.98/1.72 = 1.7

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LM1 Options Strategies 2024 Level III Notes

The expected payoff from Option C is 45 – 37.80 = 7.2. The profit is 7.2 – 3.46 = 3.74. The
profitability is 3.74 / 3.46 = 1.1
Therefore, Option B is the most profitable.

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