## Friday, December 7, 2012

### Options 2.0 – Part 11. Short Call Spread.

Today I’m going to outline the third option strategy with two legs: the Short Call Spread.

Structure
The Short Call Spread consists of two legs; the Purchase of a Call option and the Sale of a Call option with the same expiration date and a lower strike price. .

Application
A Short Call Spread is useful if you anticipate a (small) decline in the price of the underlying asset.
A Short Call Spread can be used in three different ways:
• Defensive; both strike prices out-of-the-money;
• A consistent market price results in maximum profit upon expiration; market price must increase to lowest strike price.
• Offensive; highest strike price (long call) out-of-the-money, lowest strike price (short call) in-the-money;
• A consistent market price results in profit upon expiration.
• A (small) market price drop to the lowest strike price is required for maximum profit.
• Aggressive; both strike prices in-the-money;
• A consistent market price results in maximum loss upon expiration.
• The market price must drop to the lowest strike price for maximum profit upon expiration.
Investment
The investment is negative (you receive money) and amounts to the price of the Short Call Spread (= price of the sold Call minus the price of the purchased Call option) x the number of contracts that you trade x contract size.
For example – if you buy 10 Call options 340 for 5.30 and sell 10 Call options with a lower strike price 330 for 11.65 then you’ll receive a balance of (11.65 - 5.30) * 10 * 100 = 6.35 * 1.000 = EUR 6,350.

Margin
The Short Call Spread strategy does have a margin requirement. The Margin amounts to the difference between the two strike prices.
In the example above this is EUR 10 (= 340 - 330). 10 Short Call Spreads amounts to EUR 10 * 10 * 100 = EUR 10,000. You cannot use the amount that you receive for other purposes. You must maintain a EUR 10000 - 6350 = EUR 3.650 Margin.

Yield
In order to calculate your return correctly you must take the Margin requirement into account. The return is the profit divided by the Margin x 100%.

The advantage of the Short Call Spread is that a small Margin can achieve a high return at consistent market prices and / or small price declines.

The disadvantage of the Short Call Spread is that if the price upon expiration is more than the highest strike price, you can lose the entire investment and Margin.

Case study (based on lunchtime prices Tuesday, 4th December):
The AEX lists 338,50 at this particular moment in time.
Suppose that we buy a Call option on the AEX-index with a maturity of more than one month and a strike price of 340.00 for a price of EUR 5.30. And we sell a Call option on the AEX-index with the same expiration date and a lower strike price of 330.00 for a price of EUR 11.65.
This Short Call Spread initially fetches 6.35 (= 5.30 - 11.65).
The Short Call Spread requires a Margin of 3.65 (= (340.00 - 330.00) - 6.35).
At a consistent price, a loss of 2.15 (= 2.15 / 3.65 = -59%) will be realised upon maturity.
The AEX price must decline by 2.15 (from 338.50 to 336.35 = -0.6%) upon expiration, in order to break even.
Below 336.35 upon expiration and you’ll achieve a profit using this strategy.
Below 330.00 (-2.5%) upon expiration and you’ll achieve the maximum profit using this strategy. The maximum profit is 6.35 at a margin of 3.65 (= +174%).

Pitfalls
The traditional pitfall for private investors using Short Call Spreads is to trade in "aggressive" in-the-money Short Call Spreads, in the hope that the price of the underlying asset falls sufficiently with time. Whilst the potential maximum yield is extremely high, the investor may lose sight of the fact that if the price remains constant, the Margin evaporates.
Consider investing in more offensive or defensive Short Call Spreads instead, which may offer a lower maximum profit, but result in a much smaller loss (or gain) at a consistent underlying asset price.

Please refer to the table above for sample calculations (at expiration) for various Short Call Spreads on the AEX with a maturity of one month:
• For an aggressive Short Call Spread 330-320, the AEX must drop by 5.5% to 320 upon expiration for a maximum profit of 440% (8.15 as compared to 1.85 margin).
• If the AEX lists more than 330 (-2.5%) upon expiration the loss is 100%.
• Break-even is achieved at an AEX of 328.15 (-3.1%).
• For a defensive Short Call Spread 350-340, the AEX must rise by 0.4% to 340 upon expiration for a maximum profit of 54% (3.50 as compared to 6.50 margin).
• If the AEX lists more than 350 (3.4%) the loss will be 100%.
• Break-even is achieved at an AEX of 343.50 (+1.5%).

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

## Friday, November 16, 2012

### Options 2.0 – Part 10. Long Put Spread.

Today I’m going to outline the second option strategy with two legs: the Long Put Spread.

Structure
The Long Put Spread consists of two legs; the Purchase of a Put option and the Sale of a Put option with the same expiration date and a lower strike price.

Application
A Long Put Spread is useful if you anticipate a (small) decrease in the price of the underlying asset.
A Long Put Spread can be used in three different ways:
• Defensive; both strike prices in-the-money;
• A consistent market price results in maximum profit upon expiration
• Offensive; highest strike price in-the-money, lowest strike price out-of-the-money;
• A consistent market price results in profit upon expiration
• The price must drop to the lowest strike price for maximum profit upon expiration
• Aggressive; both strike prices out-of-the-money;
• A consistent market price results in maximum loss upon expiration
• The market price must drop to the lowest strike price for maximum profit upon expiration

Investment
The investment amounts to the number of contracts you trade x the contract size  x the price of the Long Put Spread (= Price of purchased Put minus the price of the sold Put option). If you buy 10 Put options for 11.05 and you sell 10 Put options for 5.75 you pay a balance of 10 * 100 * (11.05 to 5.75) = 1.000 * 5.30 = 5.300 euros.

Margin
The Long Put Spread strategy has no margin obligation.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the purchased Put option - / - the price you paid for the Long Put Spread.

Maximum Profit
The maximum profit in a Long Put Spread is limited. Upon expiration, the maximum profit is equal to the strike price of the sold Put option minus the exercise price of the purchased Put option minus the price you paid for the Long Put Spread.

Maximum Loss
Your maximum loss is equal to your investment. If the price of the underlying asset is equal to or higher than the strike price of the purchased Put option upon maturity, then no intrinsic value will remain for either Put option. The Put options will expire at 0 and you’ll lose your investment.

The advantage of the Long Put Spread is that a small investment can realise a high return at consistent market prices and / or small price decreases.

The disadvantage of the Long Put Spread is that if it expires at a price that is more than the highest strike price then you’ll lose the entire investment.

Example (based on closing prices of Monday 12th November):
The AEX lists 332.33 at this particular moment in time. Suppose we buy a Put option on the AEX-index with a maturity of one month and a strike price of 340.00 for a price of EUR 11.05. And we sell a Put option on the AEX-index with the same expiration date and a lower strike price of 330.00 for a price of EUR 5.75.
This Long Put Spread costs 5.30 (= 11.05 - 5.75).
One Long Put Spread requires an investment of EUR 530 (=1 x 100 x (11.05 - 5.75) = 100 x 5.30).
The Long Put Spread has an intrinsic value of 7.67 (= 340.00 - 332.33).
With this Long Put Spread you sell for a balance of 7.67 - 5.30 = 2.37 time value. At a consistent market price, this is accrued the more the maturity decreases.
At a consistent price you’ll realise a profit of 2.37 (=+45%).
The AEX price must increase by 2.37 (from 332.33 to 334.70 = +0.7%) upon expiration, in order to break-even.
Below 334.70 and you’ll realise a profit using this strategy.
Below 330.00 (-0.7%) upon expiration and you’ll realise the maximum profit using this strategy. The maximum profit is (340.00 - 330.00) - 5.30 = 10.00 - 5.30 = 4.70 at an investment of 5.30 (=+89%).

Upon expiration your results are as follows:
 AEX Price Long Put 340 Intrinsic Short Put 330 Intrinsic Long Put Spread Intrinsic Long Put Spread Profit Profit In EUR Comment 315,00 25,00 15,00 25,00 – 15,00 +4,70 +4.700 Max Profit 320,00 20,00 10,00 20,00 – 10,00 +4,70 +4.700 Max Profit 325,00 15,00 5,00 15,00 – 5,00 +4,70 +4.700 Max Profit 330,00 10,00 0,00 10,00 – 0,00 +4,70 +4.700 Max Profit 334,70 5,30 0,00 5,30 – 0,00 0,00 0 Break-Even 335,00 5,00 0,00 5,00 – 0,00 -0,30 -300 Max Loss 340,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss 345,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss 350,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss

Pitfalls
The traditional pitfall for private investors using Long Put Spreads is to purchase "aggressive" out-of-the-money Put Spreads, in the hope that the price of the underlying asset falls sufficiently with time. Whilst the potential maximum yield is extremely high, the investor may lose sight of the fact that if the price remains constant then the entire investment evaporates.
Consider investing in more offensive or defensive Long Put Spreads instead, which may offer less in terms of maximum profit, but result in a much smaller loss (or even profit) at a consistent underlying asset price.

Please refer to the above table for sample calculations (upon expiration) of various Long Put Spreads on the AEX with a maturity of one month:
• For an aggressive Long Put Spread 320-310, the AEX must drop by 6.7% to 310 upon expiration for a maximum profit of 545% (8.45 as compared to 1.55).
• If the AEX lists more than 320 (-3.7%) upon expiration then the loss will be 100%.
• Break-even is reached at an AEX of 318.50 (-4.2%).
• For a defensive Long Put Spread 350-340, the AEX must rise by 2.3% to 340.00 upon expiration for a maximum profit of 27% (2.10 as compared to 7.90).
• If the AEX lists more than 350 (+5.3%) then the loss will be 100%.
• Break-even is reached at an AEX of 342.10 (+2.9%).

Webinar "Smarter Investing with Investment Tools"
On Wednesday 14th November at 20:00, the AEX College of NYSE Euronext in partnership with Finodex, will run a free webinar. You can subscribe up until 19:30 on 14th November via: http://www.aex.nl/aex-college/webinars/inschrijven.
Until then,

I wish you much success and plenty of fun with your investments!

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

## Friday, October 26, 2012

### Options 2.0 – Part 9. Long Call Spread

Options strategies with two legs
Today we’re going to make a start on option strategies with two legs: two options cleverly combined to optimally tune the Risks and Rewards. And we’ll highlight all of the pros and cons.

We’re going to combine two options, to create option strategies with two legs, such as:

Today I’m going to outline the first option strategy with two legs: the Long Call Spread.

Structure
The Long Call Spread consists of two legs; the Purchase of a Call option and the Sale of a Call option with the same expiration date and a higher strike price.

Application
A Long Call Spread is useful if you anticipate a (small) increase in the price of the underlying asset.
A Long Call Spread can be used in three different ways:
• Defensive; both strike prices in-the-money;
• The market price must fall to the highest strike price for maximum profit
• Offensive; lowest exercise price in-the-money, highest strike price out-of-the-money;
• A consistent market price results in profit upon expiration
• A market price increase equal to the highest strike price is required for maximum profit
• Aggressive; both strike prices out-of-the-money;
• A consistent market price results in maximum loss
• The market price must increase to the lowest strike price + the price of the Long Call Spread for a break-even result
• The market price must increase to the highest exercise price for maximum profit

Investment
The investment amounts to the number of contracts that you trade x the contract size x the price of the Long Call Spread (= price of the purchased Call minus the price of the sold Call option). If you buy 10 Call options for 10.25 and sell 10 Call options for 6.65 then you pay a balance of 10 * 100 * (10.25 - 6.65) = 1.000 * 3.60 = 3,600 euros.

Margin
The Long Call Spread strategy has no margin obligation.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the purchased Call option + the price that you paid for the Long Call Spread.

Maximum Profit
The maximum profit in a Long Call Spread is limited. Upon expiration, the maximum profit is equal to the strike price of the sold Call option minus the exercise price of the purchased Call option, minus the price you paid for the Long Call Spread.

Maximum Loss
Your maximum loss is equal to your investment. If the price of the underlying asset is equal to or less than the strike price of the purchased Call option upon maturity, then no intrinsic value remains for either Call option. The Call options expire at 0 and you lose your investment.

The advantage of the Long Call Spread is that a small investment can achieve high returns at consistent market prices and / or small price increases.

The disadvantage of the Long Call Spread is that if it expires at a price that is less than the lowest strike price then you’ll lose the entire investment.

Example (based on closing prices of Friday, 19th Oct.):
Suppose we buy a Call option on the AEX-index with a maturity of one month and a strike price of 330.00 for a price of EUR 6.65. And we sell a Call option on the AEX-index with the same expiration date and a higher strike price of 335.00 for a price of EUR 3.85. The AEX lists it at 334.17 at that particular moment in time.
The Long Call Spread has an intrinsic value of 4.17 (= 334.17 - 330.00).
This Long Call Spread costs 2.80 (=6.65 – 3.85).
One Long Call Spread requires an investment of EUR 280 (= 1 x 100 x (6.65 - 3.85) = 100 x 2.80).
With this Long Call Spread you sell for a balance of 4.17 - 2.80 = 1.37 time value. This is accrued as the duration decreases.
At a consistent market price you can achieve a profit of 1.37 (= 49%).
The AEX price must fall to 1.37 (from 334.17 to 332.80 = -0.4%) in order to break even.
Above 332.80 and you’ll realise a profit using this strategy.
And above 335.00 (0.25%) upon expiration, then you’ll realise the maximum profit using this strategy. The maximum profit is 335.00 - 330.00 - 2.80 = 5.00 - 2.80 = 2.20 at an investment of 2.80 (= 78%).

Upon expiration your results are as follows: