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 / 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)
A Long Call consists of a single leg; the Purchase of a Call option.

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.

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.

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.

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.

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.

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 ( 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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