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)

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.

__Advantages__

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.__Disadvantages__

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:

Call option premium:
1.00

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.*

## No comments:

## Post a Comment