## Wednesday, August 29, 2012

### Options 2.0 - Part 6. Basic Options Strategies; Long Put

The original column has been published in Dutch on August 28 at Telegraaf's DFT.nl / Goeroes / Opties 2.0 – deel 6. Basis Optiestrategie; Long Put

Basic options strategies
In my previous article of August 24th, "Basic Option Strategies", you read all about the 4 basic option strategies. And we covered the first strategy, the Long Call.
Today I’m going to talk about the second basic option strategy: the Long Put.

Long Put (Buying a Put option)
Structure
The Long Put consists of a single leg; Buying a Put option.

Application
A Long Put becomes attractive when you expect a (significant) decrease in the price of the underlying asset. Upon expiration, this price decrease must compensate for the time value included in the Put option premium at the time of purchase.
A Long Put can also provide protection for your portfolio.

Investment
The investment amounts to the number of contracts that you purchase x the Put option price x the contract size. If you buy 4 Put options for 12.50 you pay 4 * 12.50 * 100 = 5,000 Euros.

Margin
The Long Put 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 Put option minus the price that you paid for the Put option. The Put option now has only an intrinsic and no longer a time value. Which is why your result is 0.
So, to achieve the break-even point, there must always be a decrease in the price of underlying asset.

Profit
You’ll make a profit upon expiration if the price of the underlying asset is below the break-even point.

Maximum Profit
The maximum profit that can be achieved using a Long Put is equal to the strike price of the Put option minus the purchase price of the Put option. Upon expiration, the Put has a value equal to the strike price minus the price of the underlying asset. So the lower the price of the underlying asset, the more the Put option will be worth and the better your result.

Loss
You’ll make a loss upon expiration if the price of the underlying asset is above the break-even point.

Maximum Loss (Risk)
Your maximum loss is equal to your investment. If upon expiration, the price of the underlying asset is equal to or higher than the strike price of the Put option, the Put option will have no remaining intrinsic value. The Put option will expire at 0 and you’ll have lost your investment.

Price of the Underlying Asset (Delta) Influence
Negative. A Long Put has a negative Delta. A higher underlying asset price results in a lower Put option premium.

Remaining Maturity (Theta) Influence
Negative. Time works to your disadvantage with a Long Put strategy, because the remaining time value of the Put option reduces daily.

Volatility (Vega) Influence
Positive. A higher volatility indicates a greater remaining time value for the Put option and thus a higher Put option premium.

The advantage of the Long Put is that the potential profit is more or less unlimited.
But be careful. An unlimited gain might sound tempting. But there is also a downside. The chance that you’ll make a huge profit is extremely limited. Firstly, because the price of the underlying asset must usually decrease dramatically. And Secondly, because you’ll normally have already taken your profit at a much earlier stage.

The disadvantage is that if you want to achieve a profit with a Long Put, then the price of the underlying asset upon expiration must have at least decreased in line with the time value that is included in the Put Option purchase price at the time of investment.

Example
Suppose that we buy a Put option on the AEX-Index with a strike price of 345.00 for a price of EUR 12.50. The AEX lists it at 335.77 at that moment in time.
One Put option requires an investment of 1 x 12.50 x 100 = EUR 1,250.
The Put option premium includes a time value of 1.23. Thus 12.50 – intrinsic (= 345.00 – 335.77) = 12.50 – 9.23 = 3.27. So the AEX price must decrease upon expiration by 3.27 (from 335.77 to 332.50 = -1%) in order to reach the break-even point. And if the price were to drop below 332.50 we would achieve a profit using this strategy.

Upon expiration the outcome would be as follows:

Long Put Graphical Simulation:
The x-axis shows the various price levels of the underlying asset.
The y-axis displays the (expected) result. The blue line indicates the expected result one month prior to expiration. The red line shows the result upon expiration.

Pitfalls
The most common pitfall for private investors using Long Puts is to purchase “cheap”, short-term, out-of-the-money Put options, in the expectation (=hope) that the price of the underlying asset will drop sharply with time. The statistical probability of such a rate decrease before expiration is usually quite small. In fact, this type of option often expires at 0. Which results in a 100% loss. If the rate decreases, you must already have realised a substantial percentage gain, to be able to absorb the loss of the previous / following return. Please refer to the simplified calculation for Long Calls.

Options 2.0 ... Basic Options Strategy; Short Call
In this article we’ve taken a look at the second basic option strategy with a single leg; the Long Put. And we’ve covered how to use it and what the advantages and disadvantages are.
In the next article we’ll examine the third basic single leg options strategy; we’ll explore the Short Call.

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, August 24, 2012

### Options 2.0 - Part 5. Basic Options Strategies.

The original column has been published in Dutch on August 23 at Telegraaf's DFT.nl / Goeroes / Opties 2.0 – deel 5. Basis Optiestrategieen

Basic options strategies
In my previous article of August 2nd, "Options Greeks", you read all about Moneyness and what the Options Greeks could do for you, as an options investor. Options Greeks enable you to look ahead and, to a certain extent, allow you to predict the future behaviour of options prices.
Today we’re going to make a start on some basic options strategies. In other words, how we can cleverly combine options and what the advantages and disadvantages of this are.

We’ll embrace two types of options, Call and Put options.
You can Buy and Sell these options.
Which immediately creates the first 4 basic options strategies:
• Long Call (Buy a Call option)
• Long Put (Buy a Put option)
• Short Call (Sell a Call option)
• Short Put (Sell a Put option)
We’ll cover these 4 basic option strategies in the next 4 articles.
In today's article I’m going to focus on the first strategy: the Long Call.

Long Call (Buying a Call option)
Structure
A Long Call consists of a single leg; the Purchase of a Call option.

Application
A Long Call becomes attractive when you expect a (significant) increase in the price of the underlying asset. Upon expiration, this price increase must compensate for the time value included in the Call option premium at the time of purchase.
A Long Call can also be used as an alternative to the purchase of shares.

Investment
The investment amounts to the number of contracts that you purchase x the Call option price x the contract size. If you buy 4 Call options for 12.00, then you’ll pay 4 * 12.00 * 100 = 4,800 Euros.

Margin
The Long Call 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 Call option + the price that you paid for the Call option. The Call option now has only an intrinsic and no longer a time value. Which is why your result is 0.
So, to achieve the break-even point, there must always be an increase in the price of underlying asset.

Profit
You’ll make a profit upon expiration if the price of the underlying asset is above the break-even point.

Maximum Profit
The maximum profit that can be achieved using a Long Call is unlimited. Upon expiration, the Call has a value equal to the price of the underlying asset minus the strike price. So the higher the price of the underlying asset, the more the Call option will be worth and the better your result.

Loss
You’ll make a loss upon expiration if the price of the underlying asset is below the break-even point.

Maximum Loss (Risk)
Your maximum loss is equal to your investment. If upon expiration, the price of the underlying asset is equal to or lower than the strike price of the Call option, the Call option will have no remaining intrinsic value. The Call option will expire at 0 and you’ll have lost your investment.

Price of the Underlying Asset (Delta) Influence
Positive. A Long Call has a positive Delta. A higher underlying asset price results in a higher Call option premium.

Remaining Maturity (Theta) Influence
Negative. Time works to your disadvantage with a Long Call strategy, because the remaining time value of the Call option reduces daily.

Volatility (Vega) Influence
Positive. A higher volatility indicates a greater remaining time value for the Call option and thus a higher Call option premium.

The advantage of the Long Call is that the potential profit is unlimited.
But be careful. An unlimited gain might sound tempting. But there’s also a downside. The chance that you’ll make a huge profit is limited. Firstly, because the price of the underlying asset must usually increase dramatically. And Secondly, because you’ll have normally already taken your profit at a much earlier stage.

The disadvantage is that if you want to achieve a profit with a Long Call, then the price of the underlying asset upon expiration must have at least increased in line with the time value that is included in the Call Option purchase price at the time of investment.

Example (based on closing prices Monday, August 20th):
Suppose that we buy a Call option on the AEX-Index with a strike price of 325.00 for a price of EUR 12.00. The AEX lists it at 335.77 at that particular moment in time.
One Call option requires an investment of 1 x 12.00 x 100 = EUR 1,200.
The Call option premium includes a time value of 1.23. Thus 12,00 - intrinsic (= 335.77 - 325.00) = 12.00 - 10.77 = 1.23. So the AEX price must increase by 1.23 (from 335.77 to 337.00 = +0.4%) in order to reach the break-even point. And if the price were to rise above 337.00, then we would achieve a profit using this strategy.

Upon expiration the outcome would be as follows:

Long Call Graphical Simulation:
The x-axis shows the various price levels of the underlying asset.
The y-axis displays the (expected) result. The blue line indicates the expected result one month prior to expiration. The red line shows the result upon expiration.

Pitfalls
The most common pitfall for private investors using Long Calls is to purchase “cheap”, short-term, out-of-the-money Call options, in the hope that the price of the underlying asset will rise sharply with time. The statistical probability of such a rate increase before expiration is usually quite small. In fact, this type of option often expires at 0. Which results in a 100% loss. If the rate increases, you must already have realised a substantial percentage gain, to be able to absorb the loss of the previous / following return.

A simplified, back of a cigarette packet calculation:
Likelihood of profit: 20%
Likelihood of loss: 80%
If you make a 1.0 loss in 80% of cases (-100%), then you must make a profit in the remaining 20% of cases to offset the loss and a 4.0 profit (80% * -1.0 + 20% * +4.0 = -0.8 + 0.8 = 0.0) to be able to at least break even in the long run. So, using this example, if you only make a profit of 2.0, you’ll actually end up with a long-term loss: 80% * -1.0 + 20% * +2.0 = -0.8 + 0.4 = -0.4.

Options 2.0 ... Basic Options Strategy; Long Put
In this article we’ve taken a look at the first basic options strategy with a single leg; the Long Call. And we’ve covered how to use it and what the advantages and disadvantages are.
In the next article we’ll examine another basic single leg options strategy; we’ll explore the Long Put.

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.

## Thursday, August 2, 2012

### Options 2.0 – Part 4. Options Greeks.

The original column has been published in Dutch on July 18 at Telegraaf's DFT.nl / Goeroes / Opties 2.0 – deel 4. De Optie Grieken

The Greeks
In my previous article of July 18th, "The Valuation of Options", you read about the influence of the basic attributes and changing parameters that affect the formation of an option’s premium. Today I’m going to explain the Greeks.

But, first things first. Before we begin with the Greeks, let’s look at Moneyness.

Moneyness
Moneyness is a term that is frequently associated with options. Moneyness indicates the extent to which an option has intrinsic value.
There are three stages of moneyness:
• In-The-Money (ITM)
• At-The-Money (ATM)
• Out-Of-The-Money (OTM)

In-The-Money (ITM)
A Call option is in-the-money if the market price of the underlying asset is higher than the strike price of the Call option.
A Put option is in-the-money if the market price of the underlying asset is lower than the strike price of the Put Option.

These in-the-money options have both an intrinsic value plus a (limited) expected value.

At-The-Money (ATM)
An option is at-the-money if the market price of the underlying asset is (approximately) equal to the strike price of the option. This applies to both Call and Put options.
So, these at-the-money options have (virtually) no intrinsic value, but (almost) exclusively an expected value. At-the-money options have the highest expected value.

Out-Of-The-Money (OTM)
A Call option is out-of-the-money if the market price of the underlying asset is lower than the strike price of the Call option.
A Put option is out-of-the-money if the market price of the underlying asset is higher than the strike price of the Put option.
These out-of-the-money options have no intrinsic value, but rather an expected value only.

This completes our brief explanation of an option’s moneyness. It’s been conveniently summarised in the table below:

Now, moving swiftly onto the Greeks. What are they exactly? And how can I, as an option’s investor, make best use of them?

Options Greeks
Options are sensitive to changes in parameters that affect premium formation (please refer to my previous article). What makes this even more interesting, is that with options, you can actually calculate these sensitivity factors. This means that you can look ahead and analyse how an option’s value will react to certain changes in the parameters that affect premium formation.
We call these sensitivity factors the Greeks. They are:
- Delta
- Gamma
- Theta
- Vega
- Rho

I’ll take you through these Greeks one by one. And I’ll demonstrate what they can do for you. Of course, it‘s this latter point that’s counts, as after all, you’ll want to know "what's in it for me?"

Delta
Delta indicates the sensitivity of an option to a change in the price of the underlying asset.
A more simple definition is, that the Delta of an option represents the theoretical change in the option’s value if there is a point change in the price of the underlying asset.
For example:
Share XYZ is written at 52.0. Option XYZ has a value of 4.50 and a Delta of 0.62.
The Delta indicates that if share XYZ has as a one point increase, say from 52.0 to 53.0, then the value of the Delta option will also change. So, from 4.50 with 0.62 it increases to 5.12.

Call Delta
Call options have a positive Delta. Call options are worth more as the price of the underlying asset increases.
A Call option’s Delta is between 0 and 100.
A deep in-the-money Call option has a Delta of 100. These move almost 1:1 with a price change in the underlying asset.
An at-the-money Call option has a Delta of around 50. These move by around 0.50 with a 1.0 point increase in value.
A far-out-of-the-money Call option has a Delta of approximately 0. This barely moves with a price change in the underlying asset.

Put Delta
Put options have a negative Delta. Put options are worth more as the price of the underlying asset decreases.
A Put option’s Delta is between 0 and -100.
A deep in-the-money Put option has a Delta of -100. These move almost 1: -1 with a price change in the underlying asset.
An at-the-money Put option has a Delta of around -50. These move about 0.50 with a 1.0 point price drop.
A far-out-of-the-money Put option has a Delta of approximately -0. These barely move with a price change in the underlying asset.

How can I make use of Delta?
The added value of Delta is that it actually allows you to predict the price of an option, should the price of the underlying asset change!
This is a tremendous help when you are presented with an options screen that offers a dizzying selection of hundreds of options series. By looking at the Delta per option series, you'll gain a valuable insight into how the option will react to a change in the underlying asset. So, essentially you can look into the future. You need to consider this before you start investing in options.
Note that there is also a difference in the Delta’s of options with the same strike price but different maturities.

The back of a cigarette packet calculation
We can calculate this on the ‘back of a cigarette packet’ in the following way. Suppose that share XYZ is written at 52.0. You expect the price of XYZ to reach 54.5, which is an increase of 2.5 points. On the back of your cigarette pack, you can therefore multiply the Delta by the 2.5 price difference. Suppose an option with a value of 4.50 has a Delta of 0.62. By using the same cigarette packet method, the option will increase in value by 2.5 x Delta = 2.5 x 0.62 = +1.55. So, from 4.50 it increases by 1.55 to 6.05.
You can calculate various options quickly and easily using this simple technique. And ultimately select your desired option.
But be careful. Delta is not a flat, straight line. This ‘back of a cigarette packet’ method is not exact, although it does provide a good indication.
If you need a more precise calculation, then use an online Options Calculator.

Gamma
Gamma indicates the sensitivity of an option’s Delta to a change in the price of the underlying asset. Gamma is the derivative of the Delta.
A more simple definition is, that the Gamma of an option reflects a theoretical change in the option’s Delta value if there is a 1 point change in the price of the underlying asset.
For example:
Share XYZ is written at 52.0. Option XYZ has a value of 4.50, a Delta of 0.62 and a Gamma of 0.04.
The Gamma indicates that if share XYZ has a one point increase, say from 52.0 to 53.0, the Delta value of the Gamma option will also change. So, from 0.62 with 0.04 it increases to 0.66.

Gamma always has a positive value.

Theta
Theta indicates the sensitivity of an option to a change in the maturity of the option.
A more simple definition is, that the Theta of an option indicates the theoretical change in the option’s value when the remaining term of the option decreases by 1 day.
For example:
Share XYZ is written as 52.0. Option XYZ has a value of 4.50 and a Theta of -0.02.
The Theta indicates that, as the maturity decreases by 1 day, the value of the Theta option will also change. So, from 4.50 with -0.02 it decreases to 4.48.

Theta always has a negative value. An option loses expected value every day. As the remaining maturity decreases per day, so the Theta increases and the option’s value decreases. Right up until expiration, when an option will only have intrinsic value.

Vega
Vega indicates the sensitivity of an option to a change in the Volatility of the option.
A more simple definition is, that the Vega of an option reflects the theoretical change in the option’s value if there is a 1 percent point change in the option’s Volatility.
For example:
Share XYZ is written as 52.0. Option XYZ has a value of 4.50, a Volatility of 33% and a Vega of 0.10.
The Vega indicates that if the Volatility increases by 1 percentage point, say from 33% to 34%, the value of the Vega option will also change. So, from 4.50 with 0.10 it increases to 4.60.

Vega always has a positive value. The Vega of both Call and Put options, with the same maturity and strike price, is equal. As the option’s maturity decreases, the Vega becomes smaller.

Rho
Rho indicates the sensitivity of an option to a change in interest rates.
A more simple definition is, that the Rho of an option represents the theoretical change in the option’s value if there is a 1 percent point change in interest rates.
For example:
Share XYZ is written as 52.0. Option XYZ has a value of 4.50 and a Rho of 0.06. The interest rate is noted as 0.7%.
The Rho indicates that if the interest rate increases by 1.0 percentage point, say from 0.7% to 1.7%, then the Rho option’s value will also change. So, from 4.50 with 0.06 it increases to 4.56.

In the case of Call options, Rho has a positive value. With Put options, Rho has a negative value. As the option’s maturity decreases, so the Rho becomes smaller and heads towards zero.

This completes our explanation of Options Greeks. It’s conveniently summarised in the table below:

Options ... Basic Option Strategies
In this article we have outlined what the Greeks can do for you, as an options investor. We can now look ahead and, within reason, predict the future behaviour of options prices. In the next article we’ll cover basic options strategies. In other words, how we can cleverly combine options and what the advantages and drawbacks of this are.

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.