Wednesday, June 20, 2012

Options 2.0

The original column has been published in Dutch on June 13 at / 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 ( 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.

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