The original column has been published in Dutch on June 27 at DFT.nl / Goeroes / Opties, hoe zit dat ook alweer?
In our previous article on June 13, "Options 2.0", we demonstrated how you can achieve three goals with 1 simple options
transaction: you can protect your stock portfolio against a rate drop, you can increase
your return, even with consistent market rates, and finally, still maintain
sufficient upside potential in your portfolio when prices are rising.
A word of caution: be wise and ensure
that you have a sufficient basic knowledge of options, inhouse. Our Options
2.0 Basic Knowledge series provides this basic knowledge for you. It might seem
a little dry at times, but remember, it’s all for a good cause: increasing your
return.
Options Classes
You’ll hear this term frequently.
Options relate to a specific underlying asset. This may be an Index, but it can
also be an individual Stock or Currency. All options that relate to one
particular underlying asset, together form an Options Class.
There are around 115 options classes
traded on the Amsterdam markets (NYSE Liffe and TOM).
Options can be traded in up to 52
different underlying assets. These include 2 Index options (AEX Index and AMX
Index), 49 Stock options (Van Aalberts Industries and Aegon to Ziggo) and 1
Currency options class (EDX).
Options type: Call / Put options
In the Amsterdam options markets you
can trade two types of options: Call options (Buy Rights) and Put options (Sell
Rights). A call option gives the right
to buy the underlying asset (e.g. an
index, stock or currency). A Put option gives the right to sell the
underlying asset.
Options

Right

Call

Buy

Put

Sell

Exercise / Strike Price
Buying or selling the underlying
asset goes against a predetermined price. This predetermined price is called the
exercise price.
The
exercise price of an option is the price at which the purchaser of the call
option can buy the underlying asset, and / or which the buyer of a put option
can sell the underlying asset.
The
exercise price is also known as the 'Strike Price'. The concept of ‘exercise
price’ makes the definition of options more clear. A Call option (buy right)
gives the right to buy the underlying
asset at a predetermined price (strike price). And a put option (sell right)
gives the right to sell the underlying
asset at a predetermined price (strike price).
Maturity / Expiration Date
So, for how long do you enjoy the
right to buy or sell? Well, that depends on the maturity date. The right to buy
or sell the underlying asset at a predetermined price is only valid for a
limited period of time. This period runs up until a predetermined date. This
predetermined date is called the option expiration date, maturity date, or alternatively,
‘Expiry’. After the expiration date the option expires and ceases to exist.
Now we’re getting even closer to the
true definition of an option:
A Call option (buy right) gives the right to buy the underlying asset, at a predetermined price (strike price),
by a specified date (expiration date).
A Put option (sell right) gives the right to sell the underlying asset, at a predetermined price (strike price),
by a specified date (expiration date).
Buying and Selling (Writing)
You can Buy and Sell options. Sounds
straightforward, doesn’t it? But, pay attention:
You can also sell options without necessarily
having to own them. This is called writing options. By selling or writing
options, you have an obligation, rather than a right.
As a call option buyer you
have the right to buy the underlying asset at a predetermined
price.
As a call option seller you
have an obligation to deliver the underlying asset at a predetermined
price.
As a put option buyer you have
the right to sell the underlying asset at a predetermined price.
As a put option seller you
have an obligation to take the
underlying asset at a predetermined price.
Options

Buyer

Seller / Writer

Call

Buy Right

Delivery obligation

Put

Sell Right

Purchase obligation

Contract Size
In options trading the volume of
underlying assets a buyer or seller may buy or sell is also stipulated. This is
called the ‘contract size’. In Amsterdam, a standard options contract size of
100 is used. This means that if you buy 1 call option, this corresponds to 100
shares. So, if you want to purchase 500 shares, then you should buy 5 Call
options (500/100 = 5).
Again, this helps to clarify the
definition of options still further:
A Call option (buy right) gives the right to buy up until a specified date (expiration date), an agreed number
of underlying assets, at a predetermined price (strike price).
A Put option (right to sell) gives
the right to sell up until a specified date (expiration date), an agreed number
of underlying assets, at a predetermined price (strike price).
American / European style
Options can be traded during market
hours. You can Buy and Sell options.
You may exercise your right to buy
or sell at specific times. Some options can only be exercised upon expiration.
Other options can also be exercised in the interim period, between now and the
expiration date.
We call options that may be exercised
in the interim period before maturity, American style options. In Amsterdam, individual
share options are American style options. As an investor you may exercise these
in the interim period. You don’t have to wait until the option’s expiration.
Options that can only be exercised
upon expiration are called European style options. In Amsterdam, Index and Currency
options are European style options. You can only exercise these options upon
maturity. Please note, that it
is still possible and you are allowed, to trade (buy, sell) these options before
expiration during market hours. So, you don’t have to wait until expiration to
close your positions!
This makes the definition of options
yet more clear:
 An American style call option gives the right to buy an agreed number of underlying assets, at a predetermined purchase price, up until expiration.
 A European style call option gives the right to buy an agreed number of underlying assets, at a predetermined price, upon expiration.
 An American style Put option gives the right to sell an agreed number of underlying assets, at a predetermined price, up until expiration.
 A European style Put option gives the right to sell an agreed number of underlying assets, at a predetermined price, upon expiration.
Options

American style

European style

Call

Exercise up until expiration

Exercise upon expiration

Put

Exercise up until expiration

Exercise upon expiration

This ability to exercise options
early has some tricky financial implications. We’ll provide a more detailed
explanation in a future article.
Exercise
If you have purchased options, you
can sell and / or exercise them.
When you use the right to exercise your
option, we call this ‘exercising’.
Exercising a Call option allows the
owner of the call option to make use of the right to buy the underlying asset,
at the predetermined price (strike price).
Exercising a Put option allows the
owner of the Put option to make use of the right to sell the underlying asset
at the predetermined price (strike price).
Assignment
If you have sold options without owning
them, you can buy these back later or they can be ‘assigned’.
For example, a counterparty
exercises its option and you are randomly assigned to fulfil your obligation.
If the buyer wants to buy / sell, then there must be someone else to deliver /
purchase.
In the case of a Call option, the investor
who is assigned (so, the investor who holds a short call position on this
option) must deliver the underlying asset at the predetermined price (strike
price).
With a put option, the investor who
is assigned (that is, the investor who holds a short put position on this
option) must take the underlying asset at the predetermined price (strike
price).
Expiration Cycle  Monthly, Weekly
and Daily Options
Options expire on a specified date.
We call this the expiration of an option.
In Amsterdam options expire on the
3rd Friday of every month (monthly
options), as standard. In addition to these monthly options, there are also
weekly and daily options.
Weekly
options are introduced on Friday and expire the following Friday. So weekly
options have a maturity of one week.
Weekly options are available on the
AEX Index (AX1, AX2, AX4, AX5) and 6 individual stocks. These include Aegon
(trading symbol AGN with 1AG, 2AG, 4AG and 5AG. 3AG doesn’t exist, these are the standard monthly AGN options
that expire on the 3rd Friday of the month), ArcelorMittal (MT), ING
Group (ING), Koninklijke KPN (KPN), Koninklijke Philips (PHI) and Royal Dutch
Shell "AShares" (RD).
Daily options
expire every trading day. They are introduced on a particular day and expire
the following trading day. Daily options are available on the AEX index, with trading
symbols A1, A2, A3, ..., A31.
Options Value
Options have a certain value. The
value of options are defined using a number of different parameters.
We’ll now take you through the
valuation of options.
The Value of an option consists of
two components. The Intrinsic Value and the Expected Value.
Intrinsic Value:
An option has an Intrinsic Value if
the price of the underlying asset is higher than the strike price (in the case
of a call option) or lower than the strike price (in the case of a put option).
The value of an option can never be negative.
The minimum value of an option is 0.0.
In the case of a Call Option, the
Intrinsic Value of the call option is equal to the price of the underlying
asset, minus the strike price of the call option. In a formula it looks like
this:
Call option = max (0,
Underlying Asset Price  Strike Price)
For example, if share XYZ is written
at 52.0 and a call option has a strike price of 50.0, then the Intrinsic Value equals
52.0  50.0 = 2.0.
In the case of a Put Option, the
Intrinsic Value of the put option equals the strike price of the put option,
minus the price of the underlying value. In a formula it looks like this:
Put Option = max (0,
Strike Price  Underlying Asset Price)
For example, if share XYZ is written
at 52.0 and a put option has a strike price of 55.0, then the Intrinsic Value equals
55.0  52.0 = 3.0.
Expected Value
In addition to the Intrinsic Value,
an option also has an Expected Value.
The Expected Value is the value of
the option, minus the Intrinsic Value. The Expected Value can run down to 0.0,
depending on the maturity of the option.
Upon expiration, an option writes
its Intrinsic Value. Upon expiration, the Expected Value is nil. The Intrinsic
Value of an Option is the minimum value of the option, upon expiration.
Options Premium
There are a number of parameters
which affect the formation of premium. These are:
 Price of the Underlying Asset
 Strike price of the option
 Maturity of the option
 Interest
 Volatility
 Forecasted Dividend
Options Valuation ... how does that work?
So far we’ve covered the basic
features and concepts of options. This article has described how an option’s
underlying value is written. Examined Call and Put options. Explained that
you can buy and sell options. And what the Strike Price of an option is. Provided
the definition of an Expiration Date. Contract Size. American and European
style options. Described the Exercise and Assignment of options and the various
Expiration Cycles. And finally, we’ve looked at the Value of Options, including
Intrinsic and Expected Value.
We’ll delve more deeply into the
parameters and the influence of these parameters on the valuation of options,
in our next article.
Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online
investment tools for private equity and options investors. These cuttingedge
tools allow investors to make a comprehensive market analysis, complex
calculations and appropriate selections, at just the touch of a button.