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BASICS FUNDAMENTALS TECHNICALS ROLLING TC-2000 OPTIONS |
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We saw in Options - Basics an actual Options quote on Fore Systems Inc., FORE, from newspapers dated 1/7/99. This showed the role "time" plays in the premiums paid for the options. In the following, we repeat a portion of the 1/7/99 quote and a more recent quote, 1/20/99, 13 days later from the Investors Business Daily. This shows graphically the reason many find options trading so exciting.
Point 3(c) from the summary in Options-Basics:
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Dealing strictly with options, had we bought a $22.50 February Call (naked) on 1/7/99 and sold it thirteen days later we would have realized a 44% gain (1235% APR)! If that isn't exciting you need oxygen.
But what's the down side? The manic nature of the market, particularly where severe volatility is the norm, heightens the risk. That kind of an upward swing has its counterpart in the opposite direction. Look at the next figure, showing two similar stock quotes for the Borders Group (BRG).
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So it goes both ways. This is a great example of the Risk/Reward ratio, how they go up or down together. We will take advantage of the leveraging feature of options (Reward) with a calculated uncertainty (Risk) and try to tilt the Risk/Reward ratio in our favor. But first, let's understand how option prices are determined.
We said earlier that the option premiums were based on value and time. Since an option is a fixed-time investment, the time portion of the price decreases as the expiration date approaches. The value portion depends on what the stock price is doing.
The important issue: Where the stock price is relative to the strike price.
We have three possibilities (and names) for a call option:
- The stock price equals strike price. At-the-Money
- Stock price is above the strike price In-the-Money
- Stock price is below the strike price Out-of-the-Money
If the call option strike price is $22.50, we have for the stock price ;
Case 1: Regarding our covered call strategy: If we bought 100 shares (1 contract) of FORE when the price was $19.25 ($1925) on 1/7/99, we could turn right around and sell a call on the stock we now own. A $22.50 Call for February would have brought into our account (the very next day) 100 x 1 1/8 = $112. That's cash we can spend or put to work! We lose control over the stock we just purchased until the 3rd Friday in February. If the stock moves above the strike price we will be called out at $22.50 realizing $437 profit in 6 weeks ($2250 [what we sold the stock for] - $1925 [less what we paid for it] + $112 [what we made selling the option], less commissions). That's about a 22% return (190% APR). If we aren't called out, we regain control of the stock and may choose to sell another call. (Our example shows a one-contract transaction. Commission costs will be less for larger volume but must be considered in finding actual return)
Case 2: Let's change our sequence a bit by buying the stock as before but waiting for the stock price to increase before selling the call. In the quotes on FORE above, the price for the call on 1/20/99 was 1 5/8 ($1.63). Had we waited two weeks while the stock price strengthened, our return would have been $51 higher ($163 - $112), with the return of 25% (instead of the 22% in the last example). This may not seem a lot but it is this level of detail that spells the difference between home runs and ho-hums.
Now let's look at an example of option prices as the stock price moves up. Look at three quotes, taken from the IDB on three dates, for Iomega (IOM). This shows the stock price, the option premium and the time left to expiration on each date for an In-the-money call option. Also shown is the open interest on each date. Take a minute and study this table to find these.
In this example we can see how the premium changes as time approaches expiration. Initially, the premium has both time and value content. In this, an In-the-money call, the premium has intrinsic value because the stock price is already above the strike price.
However, the option premium is larger than this intrinsic value, because of the added time value. As time approaches expiration, the time value goes to zero and the premium is all intrinsic value. In this example, as the time value decreased, its intrinsic value increased with the increasing stock price.
Take another look at Iomega with an Out-of-the-money call for the same time period:
In this case, the premium is not so easily defined. There is no intrinsic value and the premium is much less, primarily only time value. Expiration day was the 15th of February, the third Friday. The reason the premium has any value at all in Table 2 is the newspaper date was 1/15/99, but it reported Thursdays prices on the 14th. The premium would be worthless on Friday without a dramatic rise in stock price that day.
To further lock these ideas in, look at the February calls for Iomega during the same time frame showing both the $7.50 C and $10.00 C in the table below.
Notice how the premiums compare to the January calls. In each case they are higher for the February calls. Everything else is equal, only the time to expiration is longer. There is more time for the stock to react in the way we want it to. There is more time value.
In next section, we will put all this information into a stock play to make it clear why we're spending this much time on the preliminaries.
Summary:
- Understanding how options are priced will increase our confidence in venturing into the options market.
- An option premium is basically made up of two parts:
- Intrinsic value - the portion of the premium that is equal to the degree that it is In-the-money. If I own a $15.00 February Call and the stock price is $16.50, I can exercise the option for $15.00, sell it on the market and pocket $1.50. The option has an intrinsic value of $1.50.
- Time value - related to the "hope" that the stock will react in the right way for us. The more time to expiration, the more chance of this taking place. Therefore, time value decreases to zero at expiration date.
- Several factors contribute to the exact time value. Three important factors are:
- Stock price - Options on a $100 stock will have greater time value than one trading at $20.
- Volatility - The greater the movement of stock price, the higher the time-premium.
- Supply & Demand - The more people trying to buy, the higher the time value.
- Because the price of an option will increase tick for tick with the stock after it becomes In-the-money, the leverage of option trades is its most attractive feature. We can control expensive stocks with a relatively small investment and take advantage of the increases that follow even blue chippers.
- Leverage requires a stock to react in the way we want. If we buy a call, the stock must increase for us to benefit.
- The attendant risk of buying a call is that the stock may not increase, or even go down. We can lose all of our investment because the option is a fixed time vehicle. It not only has to go in the right direction, but it must do so within a specific amount of time.
- If we own a stock, we can write (sell) a call for a premium and agree to sell it if it reaches a specified price, called the strike price, anytime before a specified expiration date. We limit our risk in this case because if the stock does not move in the way we want, we still own the stock and can keep the premium received for selling the call. Our risk is in not being able to capture all the profits, beyond the strike price, if the stock move dramatically upward.
- Understanding: Only by a thorough understanding of the risks can we profit from the options strategy.
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