Master Element 6 (26 questions, highest weight!) covering long calls/puts, covered calls, protective puts, vertical spreads, straddles, strangles, and hedging with futures.
Derivatives Element 6: Speculating, Hedging, and Strategies (~22%)
This is the most heavily weighted section of the exam. It requires you to apply technical knowledge to construct, analyze, and calculate risk/reward profiles of various trading strategies.
Directional Speculation with Options
Speculators use options to leverage a directional view with limited risk.
Long Call
A bullish strategy where:
- Maximum loss = Premium paid
- Potential profit = Unlimited
- Break-even = Strike + Premium
Long Put
A bearish strategy where:
- Maximum loss = Premium paid
- Maximum profit = Strike - Premium (stock can only fall to zero)
- Break-even = Strike - Premium
Buying Out-of-the-Money (OTM)
High leverage but lower probability of profit; the stock must move significantly just to reach break-even.
Income and Protection Strategies
These are "conservative" strategies often used by long-term investors:
Covered Call
Selling a call option against stock you already own:
- Objective: Generate income from premium
- Risk: You cap upside potential at strike price
- Exposure: Still exposed to stock falling
Protective Put
Buying a put option for stock you own:
- Objective: Create a "floor" to limit downside losses
- Cost: Premium paid reduces returns
- Synthetic Equivalent: Same P&L profile as a Long Call
Spread Strategies
Spreads involve simultaneously buying and selling options of the same type to reduce cost and manage risk.
Vertical Bull Call Spread
Buy a lower-strike call and sell a higher-strike call:
- Profit if stock rises, but gain is capped
- Max profit = Difference in strikes - Net premium paid
- Max loss = Net premium paid
Vertical Bear Put Spread
Buy a higher-strike put and sell a lower-strike put:
- Profit if stock falls, but gain is capped
- Max profit = Difference in strikes - Net premium paid
- Max loss = Net premium paid
Calendar (Time) Spread
Buy and sell options with same strike but different expiration dates. This strategy aims to profit from faster time decay (Theta) of the near-term option.
Volatility Strategies
These strategies do NOT bet on direction, but rather on magnitude of movement:
Straddle
Buying both a Call AND a Put at the SAME strike and expiry:
- Long Straddle: Profitable if stock makes massive move in either direction
- Short Straddle: Profitable if stock stays perfectly still (risky - unlimited losses)
Strangle
Similar to straddle but using OTM options to reduce initial cost. Requires even larger price movement to profit.
Hedging with Futures
Hedging is the use of derivatives to offset existing risk:
Short Hedge (Sell Hedge)
Used by those who OWN the asset (e.g., farmer with wheat, investor with stocks) and fear price drop. They SELL futures to lock in a price.
Long Hedge (Buy Hedge)
Used by those who NEED the asset in future (e.g., bread manufacturer) and fear price increase. They BUY futures to lock in a price.
Cross Hedging
When no exact future exists for your asset, you use a highly correlated one (e.g., hedging jet fuel with heating oil futures).
Advanced Portfolio Hedging
Beta Hedging
Calculating the number of index futures needed to reduce a stock portfolio's systemic risk to zero:
Contracts = (Portfolio Value / Futures Value) x Beta
Duration Hedging
Using bond futures to protect a fixed-income portfolio from rising interest rates.
Arbitrage Strategies
- Cash and Carry: Buy physical asset and sell future when future is "overpriced" relative to cost of carry
- Reverse Cash and Carry: Short asset and buy future when future is "underpriced"
Key Exam Tips for Element 6
- Long Call = Bullish, unlimited profit, limited loss
- Long Put = Bearish, limited profit (stock to zero), limited loss
- Covered Call = Income strategy, caps upside
- Protective Put = Insurance, same profile as Long Call
- Bull Call Spread: Buy lower strike, sell higher strike
- Long Straddle: Profit from BIG moves in either direction
- Short Hedge = SELL futures to protect owned assets
- Beta Hedging formula: (Portfolio Value / Futures Value) x Beta