I just got this interview question and am not sure if I gave the correct answer. Bascially the question is how to get the payoff used in the diagram to the left using options. The diagram is basically a call spread, but instead of there being an upward sloping diagonal line connecting the two flat horizontal payoffs from the options, the call spread is pushed together so there is no diagonal line.
How do you generate this payoff diagram using options?
Thanks.
Trick question? Maybe I'm thinking from too much of a mathematical view but that theoretically isn't even a function as it's drawn (not 1:1).
Binary call - binary put.
no you can do it with vanillas
you just need to buy a LOT of calls and sell an equal amount of calls at like a cent higher
If you buy a call and short a put at the same strike price, you can get that shape. However, the put must be more expensive than the call for graph to be positive. For European options, this happens when D + X e^[-r(T-t)] -So > 0, D= PV of dividends, X= strike price, So=current price of stock.
I don't understand. If you long a call and short a put at the same strike price, you should essentially be getting a slanting positive line indicating a long stock position. Maybe the case is different for European options.
actually, I think I may have another way of structuring this. Long a call and short a call at the same strike price. When you approach that price, inject fixed amount of cash and then bump the p&l up buy a certain amount. Draw it out and see how it works. I remember working on something like this over the summer.
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