Sunday, February 26, 2012

Options – cash generator or money loser? Roll Over Baby!

If the price of the stock underlying a call option is on the rise then the premium of the option (i.e. the price of the option) increases. If the share price is below the strike price the premium comprises two components:

1.       The time value of the option – payment for the risk to hold onto the underlying shares and the interest you could have earned on the cash you invested to own the underlying stock.

2.       The extrinsic value of the option: a) the more volatile the stock price, the better the chance for that price to exceed the strike price; thus the writer (seller) requires a higher premium for more volatile stocks. b) The closer the stock or share price is to the strike price; the more likely it is for the stock price to exceed strike. Thus, proximity of the share price to the strike causes the premium to rise as well. These factors combined determine the extrinsic value of an option.

When time runs out for an option (i.e. your approach the expiry date of the option) and the underlying share price stays below or at strike price, the option loses value; possibly loses all value. When time runs out but with the price stock rising, chances are that the premium rises in spite of the option’s decreasing share value and contrary to the speculation by the seller (writer). If the underlying share price exceeds the strike price, intrinsic value is added and the option may become truly expensive. The seller’s losses, especially if he/she sold the options without owning the underlying stock may become significant.  Let’s first explain ‘intrinsic value’.

If the share price exceeds the strike price, a call option allows the owner to buy (call) a share for the strike price (e.g. $56) from the option writer. Next the investor turns to the stock market and sells it at market price, e.g. $57, and pockets the difference (1.00) per share.  So basically, regardless of time and extrinsic value, upon exercising the option buyer would earn a guaranteed $1.00. The difference between market price and strike price is called the intrinsic value of an option.

The total option price or premium would be time value plus extrinsic value plus intrinsic value. For the writer, the loss from selling a naked option could be unlimited. He has three ways out:

1.       Let the option expire and take the loss (buy the shares at the market price at expiry and sell them to the option buyer for the strike price plus… assignment and share purchase commissions).

2.       Buy the underlying shares now rather than at expiry when the share price may be even higher plus assignment and share purchase commissions.

3.       Buy the call option at current market price and take the loss but don’t incur the commissions for assignment and share purchase.

4.       To make up for the loss under point 3, sell some other options with a higher strike price and/or expiry farther into the future.

Basically, points 3 and 4 combined is called a ‘roll over’, because in principle the call writer extends or renews the old call option. He/she rolls the old option over into a new one hoping for a reduced loss now and a chance to make up with the new option later.

By now, you probably realize that what looked initially like a simple transaction (‘selling a call option) can become a convoluted trail of transactions with various outcomes regarding profits and losses. To make matters worse, you not only can not only buy and sell ‘Call options’ but you can do the same with ‘Put options’ or combine both call and put option transactions. We’ll be discussing ‘put options’ next.

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