A pension fund holds $50 million of equity and wants downside protection without paying for it outright. A corporate treasurer needs a contingent payout if oil tops $90 but pays nothing if it doesn't. Both problems get solved with option combinations: covered calls, protective puts, spreads, collars, and the exotic option family. The exam tests whether you can draw the payoff diagram, compute breakevens, and pick the right combination for the stated risk goal.
The two most common stock-plus-option strategies show up constantly on the FRM.
A covered call is long stock plus short call. You collect the call premium and cap your upside at the strike. Maximum profit is K - S₀ + premium. Maximum loss is the stock's full decline minus the premium. Practitioners use it to harvest income on a position they would consider selling at K anyway.
A protective put is long stock plus long put. You pay the put premium and floor your downside at K - put cost (relative to entry). Maximum loss is S₀ - K + p.
Common mistakes
- Confusing covered call with naked call. Covered call = long stock + short call. Naked call is just short call. Maximum loss on a covered call is the stock's value minus the premium received (limited because you own the stock). Maximum loss on a naked call is unlimited.
- Treating a zero-cost collar as zero-risk. Premium-neutral does not mean payoff-neutral. The cap on upside can cost the manager 10-20% of any large rally. Trap: question asks "what is the cost of a zero-cost collar?" The answer is "premium = 0; opportunity cost = upside above the call strike."
- Computing breakeven from strike rather than strike plus net cost. Bull call spread breakeven is K1 + net debit, not K1. Trap: question gives a long $50 call at 1 and asks breakeven. Candidate answers $50; correct answer is $50 + $3 = $53.
Bottom line
- Covered call (long stock + short call): caps upside at K, pays the call premium, and max loss equals stock value minus premium received (limited because you own the stock).
- Protective put (long stock + long put): a synthetic long call by put-call parity. Floors loss at ; upside is uncapped.
- Bull call spread (long low-K call + short high-K call): caps both sides, cheaper than a long call, breakeven = low strike + net debit.
- Butterfly (long K1 + long K3 + short 2 x K2, evenly spaced): a low-volatility bet that pays the most when the stock pins at K2.
Exam shortcut
When a strategy question lands, count the legs and the strikes. Two strikes, same type → vertical spread; identify by strike sign and call/put. Three evenly-spaced strikes → butterfly. Long call + long put at same strike → straddle; different strikes → strangle. Stock + put + call → collar. The trap is treating a "covered call" without underlying stock as covered, when it's actually naked.
The full lesson (about 3,228 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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