Refresher Reading
Options Strategies
2020 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
Introduction
Derivatives are financial instruments through which counterparties agree to exchange economic cash flows based on the movement of underlying securities, indexes, currencies, or other instruments or factors. A derivative’s value is thus derived from the economic performance of the underlying. Derivatives may be created directly by counterparties or may be facilitated through established, regulated market exchanges. Direct creation between counterparties has the benefit of tailoring to the counterparties’ specific needs but also the disadvantage of potentially low liquidity. Exchangetraded derivatives often do not match counterparties’ specific needs but do facilitate early termination of the position, and, importantly, mitigate counterparty risk. Derivatives facilitate the exchange of economic risks and benefits where trades in the underlying securities might be less advantageous because of poor liquidity, transaction costs, regulatory impediments, tax or accounting considerations, or other factors.
Options are an important type of contingentclaim derivative that provide their owner with the right but not an obligation to a payoff determined by the future price of the underlying asset. Unlike other types of derivatives (i.e., swaps, forwards, and futures), options have nonlinear payoffs that enable their owners to benefit from movements in the underlying in one direction without being hurt by movements in the opposite direction. The cost of this opportunity, however, is the upfront cash payment required to enter the options position.
Options can be combined with the underlying and with other options in a variety of different ways to modify investment positions, to implement investment strategies, or even to infer market expectations. Therefore, investment managers routinely use option strategies for hedging risk exposures, for seeking to profit from anticipated market moves, and for implementing desired risk exposures in a costeffective manner.
The main purpose of this reading is to illustrate how options strategies are used in typical investment situations and to show the risk–return tradeoffs associated with their use. Importantly, an informed investment professional should have such a basic understanding of options strategies to competently serve his investment clients.
Section 2 of this reading shows how certain combinations of securities (i.e., options, underlying) are equivalent to others. Section 3 discusses two of the most widely used options strategies, covered calls and protective puts. In Section 4, we look at popular spread and combination option strategies used by investors. The focus of Section 5 is implied volatility embedded in option prices and related volatility skew and surface. Section 6 discusses option strategy selection. Section 7 demonstrates a series of applications showing ways in which an investment manager might solve an investment problem with options. The reading concludes with a summary.
Learning Outcomes
The member should be able to:
 demonstrate how an asset’s returns may be replicated by using options;

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;

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;

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;

compare the effect of buying a call on a short underlying position with the effect of selling a put on a short underlying position;

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;

describe uses of calendar spreads;

discuss volatility skew and smile;

identify and evaluate appropriate option strategies consistent with given investment objectives;
 demonstrate the use of options to achieve targeted equity risk exposures.
Summary
This reading on options strategies shows a number of ways in which market participants might use options to enhance returns or to reduce risk to better meet portfolio objectives. The following are the key points.

Buying a call and writing a put on the same underlying with the same strike price and expiration creates a synthetic long position (i.e., a synthetic long forward position).

Writing a call and buying a put on the same underlying with the same strike price and expiration creates a synthetic short position (i.e., a synthetic short forward 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.

Delta is the change in an option’s price for a change in price of the underlying, all else equal.

Gamma is the change in an option’s delta for a change in price of the underlying, all else equal.

Vega is the change in an option’s price for a change in volatility of the underlying, all else equal.

Theta is the daily change in an option’s price, all else equal.

A covered call, in which the holder of a stock writes a call giving someone the right to buy the shares, is one of the most common uses of options by individual investors.

Covered calls can be used to change an investment’s risk–reward profile by effectively enhancing yield or reducing/exiting a position when the shares hit a target price.

A covered call position has a limited maximum return because of the transfer of the right tail of the return distribution to the option buyer.

The maximum loss of a covered call position is less than the maximum loss of the underlying shares alone, but the covered call carries the potential for an opportunity loss if the underlying shares rise sharply.

A protective put is the simultaneous holding of a long stock position and a long put on the same asset. The put provides protection or insurance against a price decline.

The continuous purchase of protective puts maintains the upside potential of the portfolio, while limiting downside volatility. The cost of the puts must be carefully considered, however, because this activity may be expensive. Conversely, the occasional purchase of a protective put to deal with a bearish shortterm outlook can be a reasonable riskreducing strategy.

The maximum loss with a protective put is limited because the downside risk is transferred to the option writer in exchange for the payment of the option premium.

With an option spread, an investor buys one option and writes another of the same type. This approach reduces the position cost but caps the maximum payoff.

A bull spread expresses a bullish view on the underlying and is normally constructed by buying a call option and writing another call option with a higher exercise price (both options have same underlying and same expiry).

A bear spread expresses a bearish view on the underlying and is normally constructed by buying a put option and writing another put option with a lower exercise price (both options have same underlying and same expiry).

With either a bull spread or a bear spread, both the maximum gain and the maximum loss are known and limited.

A long (short) straddle is an option combination in which the investor buys (sells) puts and calls with the same exercise price and expiration date. The long (short) straddle investor expects increased (stable/decreased) volatility and typically requires a large (small/no) price movement in the underlying asset in order to make a profit.

A collar is an option position in which the investor is long shares of stock and simultaneously writes a call with an exercise price above the current stock price and buys a put with an exercise price below the current stock price. A collar limits the range of investment outcomes by sacrificing upside gain in exchange for providing downside protection.

A long (short) calendar spread involves buying (selling) a longdated option and writing (buying) a shorterdated option of the same type with the same exercise price. A long (short) calendar spread is used when the investment outlook is flat (volatile) in the near term but greater (lesser) price movements are expected in the future.

Implied volatility is the expected volatility an underlying asset’s price and is derived from an option pricing model (i.e., the Black–Scholes–Merton model) as the value that equates the model price of an option to its market price.

When implied volatilities of OTM options exceed those of ATM options, the implied volatility curve is a volatility smile. The more common shape is a volatility skew, in which implied volatility increases for OTM puts and decreases for OTM calls, as the strike price moves away from the current price.

The implied volatility surface is a 3D plot, for put and call options on the same underlying, showing expiration time (xaxis), strike prices (yaxis), and implied volatilities (zaxis). It simultaneously displays volatility skew and the term structure of implied volatility.

Options, like all derivatives, should always be used in connection with a welldefined investment objective. When using options strategies, it is important to have a view on the expected change in implied volatility and the direction of movement of the underlying asset.