Options...what are they again?

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, in-house. 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 "A-Shares" (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 cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

Options 2.0

The original column has been published in Dutch on June 13 at  DFT.nl / Goeroes / Opties 2.0

Options 2.0
You can protect your investment portfolio beautifully with options. And you can use options to generate additional income too. Of course, you can always bet speculatively on options, but we prefer risk management and extra income, every time. Options are ideally suited to this, as they allow you to positively influence your portfolio’s risk / return ratio. You should take great care then, to ensure that your calculations and analysis are flawless. After all, we don’t want any costly blunders. And that’s what our Options 2.0 series is all about: a thorough preparation of your options investment is half the return...

Favourable risk / return ratio
Having options in your investment portfolio can prevent you from running a straight 1:1 risk. You know the score: if the AEX-index is down 10%, it will cost you 10%, if the AEX-index remains unchanged, then so too does your portfolio and yes, if the AEX-index rises by 10%, then you’ll have a 10% (paper) profit on your portfolio.

In graph form it looks like this:

Let’s start from a position of 100 hypothetical AEX shares that we purchased on June 12, 2012 with a closing price of around 292 (100 x 292 = EUR 29,200). The x-axis in the graph displays the AEX rate. On the y-axis we have outlined the result. The blue line represents the result, as of today. The red line is the theoretical result during the course of one year, until June 21, 2013 (options with an expiration date of June 13th). This result is 4.5% higher than today, because the forecasted AEX dividend yield for next year is 4.5%.
So far, so good. But cleverly combine this portfolio with options, and you’ll quickly realise an improved risk / return. A neutral portfolio in combination with the writing of a call option, greatly limits your risk and significantly increases your potential return.

Neutral scenario: we write an AEX-index call option with a maturity date of June 2013 and a strike price of 300 on a bid price of 18.50.
Thanks to your option, a drop of 10% in the AEX-index now only costs you 3.7%, a static index will even provide a gain of 6.3% and an AEX increase of 10% delivers an impressive 9.1%. And all this is in addition to the expected dividend yield of 4.5%.
This neutral scenario generates an initial EUR 1,850 of extra income at the outset. That’s 6.3% or EUR 1,850 for writing a call option related to your EUR 29,200 investment in shares. You’ll lower your risk by 6.3% more than by only holding a long share position. And you’ll also earn money at a consistent AEX rate. At a whopping 6.3%. Which is good to know. At an AEX of more than 300.00, your gain on June 21, 2013 is maximised at 9.1% (EUR 1,850 + EUR 800 = EUR 2.650 / EUR 29,200 = 9.1%). The EUR 1,850 is the money you’ll receive for the call option. And the EUR 800 is the difference in the value of your shares between 292 and 300.
At an AEX of more than 300, you’ll maximise your profit by 9.1%. The additional value of shares drops off against the added value of the written call option.

In graph form it looks like this:

Let’s take a look at a defensive scenario with 1 option. This time we write an AEX-index call option with a maturity date of June 2013 and a strike price of 280 on a bid price of 28,50:
An AEX-index drop of 10% will now only cost you 0.2%, a constant index delivers 5.7%, whilst a 10% increase in the AEX-index will still result in a 5.7% gain.

Offensive scenario: we write an AEX-index call option with a maturity date of June 2013 and a strike price of 320 on a bid price of 10.50:
An AEX-index decrease of 10% will now cost you 6.4%, a static index will deliver 3.6%, whilst a 10% increase in the AEX-index will provide a 13.2% gain.

The table below details each scenario in a separate row. These portfolios all contain a small basket of shares in combination with a written call option. The result: notably less risk AND significantly higher returns.

  
Shares + Options are safer than 100% Shares!
Options may seem complex at first glance, but a little reading on the topic will reap many rewards: you’ll learn how to harness options for risk management AND improved opportunities for returns. We make it easy for you: in our informative and entertaining series of articles in Options 2.0, we demonstrate how to use options effectively. And we could all use a little investment fun!

To Play For: A daily premium of EUR 50,000,000 ...
Yes, you read it correctly: options trading in Amsterdam amounts to a DAILY total option premium (price of an option contract x number of contracts traded) of EUR 50 million. This represents a total underlying value of more than EUR 2.5 billion. Yes, billion! No wonder you’re keen to find out more.
In brief: options have been traded in Amsterdam since 1978. Although it began modestly, we now collectively trade almost 300,000 options contracts on average, per day (this average is based on the first 4 months of 2012). That means 300,000 options bought and sold, as every option needs a counterpart. So combined, these option contracts represent an option premium of almost EUR 50 million, with a total underlying value of over EUR 2.5 billion. Per day!
That’s why options trading in Amsterdam is a billion euro business and one from which we’d all like to benefit. But preferably with controlled risks and consistent returns. Naturally!

Do we have an investment plan?
Of course we do. Investing is our business and businessmen always have a plan. And, as an investor, so do you. Above all else, investors are single-minded, so when it’s going well, you’ll stick to that plan. We can help you get started. In fact, you can now put all those unwieldy excel spreadsheets behind you, in a manner of speaking.

Goodbye Excel
Sure, we’re fond of Excel too. But fonder still of convenience, speed and impeccable results.
That’s why DFT boasts a comprehensive set of investment tools that make tedious manual calculations totally redundant. These tools effectively do the donkey work for you, calculating, analysing, sorting and selecting. So now you have the opportunity to benefit from that EUR 50 million. Of course, you’ll still need a basic knowledge of options, after all you wouldn’t drive a car without a licence either. But at least you’re getting somewhere. That’s how it works with options too. And here’s the good news: we’ve just made it a whole lot easier with our comprehensive range of clever investment tools.

Options ... what are they again?
You’ve got Calls, Puts, then there’s something about premiums, Greeks and a whole list of other exotic sounding names such as Covered Calls, Long Straddles and Butterflies. The next article in our Options 2.0 series will quickly refresh your options knowledge. We firmly believe that anyone can realise an improved return on investment, simply by using options in a sensible, risk-controlled way. Or to put it more succinctly: a thorough preparation of your options investment is half the return...

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.