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CFA® Level III · Derivatives and Risk Management · free lesson
Options Strategies
Options let a portfolio manager reshape an exposure precisely: add a floor, trade upside for income, bet on volatility rather than direction, or cut market exposure without selling a share. This module builds every core strategy from its payoff at expiration, shows how delta, time decay and implied volatility drive positions before expiration, and ends with the Level III skill that matters most: choosing and justifying the strategy that fits a client's views and objectives.
What you will learn
1. Construct synthetic asset, forward and option positions with put-call parity, and compare buying a call with writing a put as ways to modify a short position in the underlying.
- Put-call parity: asset + put = call + zero-coupon bond paying X; both are worth max(S_T, X) at expiry.
- Long call + short put (same X and T) = synthetic long forward at X; adding a bond paying X gives a synthetic long asset.
- An option trading away from parity can be sold (or bought) against its synthetic to lock in the difference, before costs.
- Short asset + long call = synthetic long put: the premium buys a cap on the loss at X - S0 + c0.
- Short asset + short put = synthetic short call: limited premium income, capped gain and unlimited loss in a rally.
2. Evaluate covered call and protective put positions, including their objectives, value and profit at expiration, maximum gain and loss and breakeven price, and compare their deltas with a long asset hedged by a short forward.
- Covered call = long asset + short call: max profit X - S0 + c0, max loss S0 - c0, breakeven S0 - c0.
- Protective put = long asset + long put: max loss S0 - X + p0, unlimited upside, breakeven S0 + p0.
- Covered call objectives: income, a better selling price, reaching a target price; the cost is the capped upside.
- Long asset + short forward has delta 0; covered calls (1 - delta of the call) and protective puts (1 + delta of the put) are partial hedges.
- Covered calls are short gamma and vega; protective puts are long gamma and vega, so their exposure falls as the market falls.
3. Analyze bull and bear spreads, straddles and collars by calculating their value and profit at expiration, maximum gain and loss and breakeven prices, and explain the market view each one expresses.
- Bull call spread: max gain = (X_H - X_L) - net premium, max loss = net premium, breakeven = X_L + net premium.
- Bear put spread: max gain = (X_H - X_L) - net premium, max loss = net premium, breakeven = X_H - net premium.
- Long straddle: max loss = c0 + p0, breakevens X +/- (c0 + p0); a bet that realized volatility exceeds implied volatility.
- Collar = long asset + long put (X_P) + short call (X_C); profit is bounded on both sides.
- Short straddles and other net short option positions collect limited premium for potentially very large losses.
4. Explain how calendar spreads use differences in time decay and implied volatility across expirations, and interpret volatility skew, smile and term structure when choosing strikes and expirations.
- Long calendar spread: sell near-dated, buy longer-dated, same strike; it gains if the price stays near the strike and from rising longer-dated implied volatility.
- The maximum loss of a long calendar spread is the net debit; a large move either way hurts it.
- The implied volatility term structure normally slopes upward and inverts in stress, when short-dated volatility jumps most.
- Equity index options show a skew (OTM puts above OTM calls); currency options more often show a smile.
- Skew makes downside protection expensive: equal-distance collars cost money and risk reversals earn a credit.
5. Recommend option strategies that fit an investor's directional view, volatility view and risk objectives, and use option deltas to reach a target equity exposure.
- Bullish and expecting higher volatility: buy calls; bullish and expecting lower volatility: write puts.
- Bearish and expecting higher volatility: buy puts; bearish and expecting lower volatility: write calls.
- No directional view: buy straddles if volatility should rise; write straddles or use long calendar spreads if it should fall.
- Options needed = (target delta - current delta) / option delta; divide by the multiplier to get contracts.
- Long puts add positive gamma and written calls negative gamma, so equal starting deltas diverge as the price moves.
Module at a glance
- Put-call parity (S0 + p0 = c0 + PV(X)) lets you build any position synthetically and spot mispriced options.
- Short asset + long call caps a short seller's loss; short asset + short put only adds limited premium.
- Covered call: income for capped upside, breakeven S0 - c0. Protective put: insurance, maximum loss S0 - X + p0.
- Spreads and collars give up a tail to cut the premium; always get the sign of the net premium right.
- Long straddles bet that realized volatility will exceed implied volatility; short straddles carry very large risk.
- Long calendar spreads sell near-dated time value and are net long vega; equity skew makes puts expensive relative to calls.
- Choose strategies by directional and volatility view, then by risk objective; set exposure with N = (target - current delta) / option delta.
This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.