AuthorTopic: Overwhelmed by Options! Help/Advise?
williamtopguy
@2014-05-11 16:43:34
Hello everyone,

I'm completely overwhelmed by the options section for level 1! I'm using the CFA books and am having a hard time understanding the various intricacies of options (i'm fine with futures and forwards).

With regards to options, I understand the basic format of puts and calls and how one makes money off going long/short each one.. but am struggling with completely understanding the nuts and bolts of the section.. for example i'm struggling with:

1. the maximum and minimum values of European options and American options
2. how the max and min Values for options are different for the max/min Bounds for options
3. put-call parity

basically.. considering options are a small part of level 1, I don't feel like spending an inordinate amount of time studying for this section. Can anyone share how in-depth we need to know this section? For example, are we required to memorize the formulas for constructing synthetic options?

Thanks so much for your help!
chiawen
@2014-06-02 03:53:23
hi there,

2.
there is not so much a difference... the boundaries are just a more strict refinement of the min/max values... in fact, if you compare those you will notice that the boundaries give a more strict minimum lower value for the option instead of just saying they must be >=0.

1.
if you have problems deriving the results, dont worry, you're just expected to know the boundaries. although in my opinion, being able to derive results gives a more intuitive understanding..

i don't want to rewrite the passage from my AN study notes, but the general idea is as follows:

(for minimum Euro-call value)
that they create a portfolio out of stock, call option, and cash, which at maturity will always have a positive or zero value (depending on what the spot price is), thus it MUST have a positve value today (>=0).
then they just re-arrange the terms, i.e. solve for the call value.

the american call must be worth at least as much, because it gives more flexibility! i.e. C>=c
note that for a non-dividend paying stock, early exercise is not favourable..

(for minimum euro-put value)
same logic as with call. construction of a portfolio that yields +/0 payoff at maturity... this must be >=0. re-arrange..

for the american put however, early exercise might be favourable, thus in this case the lower value is different for the amercian option.

3. PCP
the logic is, that the a fiduciary call and a protective put at maturity will always have the same payoff, thus the two strategies must have an equal value.

fiduciary call (FC)= zero-bond (face=X) long + call long (strike=X)
protective put (PP) = stock long + put long (strike=X)

let's say S(T)>X (call has value, put doesn't)
FC=X+(S(T)-X)=S(T)
PP=S(T)+0=S(T)

alternatively, let's say S(T) FC=X+0=X
PP=S(T)+(X-S(T))=X
=> FC=PP

in present value terms: PV(X)+c(0)=S(0)+p(0) et voilą, here goes the PCP..

with synthetic options, do you mean building the tracking portfolio (a portfolio that has equal payoffs than the option; usually we need this for calculating arbitrage profits)? then yes, you are expected to know that... but good news, just re-arrange the PCP.

cheers

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