Saturday, March 3, 2012

Options – cash generator or money loser? What if scenarios

By now you should have a good idea what options are; that there are two types of options: puts and calls; and you may understand the reasons for buying options.

To summarize there are three reasons:

1.       To increase income or create cash flow

2.       To insure your portfolio or part there off

3.       To make option trading profits.

To successfully deal with options you have to be able to understand the probable outcomes (I do not necessarily say risks) of an option trade or a combination of option and stock trades. So let’s examine these possible outcomes or ‘What-If’ scenarios. If you are like me, you can best asses this by making a graph.
The premium of an option is based on time value, intrinsic value and extrinsic value. Let’s first get a feeling or graph the time value of an option, say our good old RY call options. In February you could buy Royal Bank (RY) call options with strike prices that amongst others ranged from $52 to $58 while the share price was $53.23. You could buy these calls with a range of expiry dates starting on February 18, 2012 and going all the way out to January 18, 2014. The data for these options you can find on-line with your discount broker. The data for our example are shown in table 1.
Table 1
You now can graph these numbers to better grasp their meaning (figure 1).
Figure 1
On the vertical axis is the option premium or price and on the horizontal axis is the time over which the various options expire. The blue series 1 represent the options with a strike price of $52 and they are ITM (in the money); since the share price is currently $53.23, the right to buy them at $52 is worth $53.23 - $52 =$1.23, i.e. the intrinsic value of the option. It is obvious from the graph that the nearer to expiry an option is, the cheaper it becomes, that is the time value option. For options with a strike price above the current share price, i.e. those options who are OTM (out of the money) the intrinsic value is zero.
So let’s remove the intrinsic value from each of the series buy deducting the intrinsic value for each series from their premiums and then re-do the graph (fig 2).
Figure 2
If the graph in figure 2 only represented time value they would overly each other perfectly. That is not the case because there are other value contributors to the option premium which are put in the category of ‘extrinsic value’. Some of those factors are the volatility of the underlying stock price; after all it is much riskier to predict the future share price three months of a volatile stock than that of a stock that barely changes. Also, the proximity (nearness) of the share price to the strike price adds value since the chance of going into the money is much better for a strike price just below the current share price than one that is several dollars lower.

But overall, the trend of time value is clear and by itself time value can make up a significant part of the option’s premium. In case if the RY options the average option premium 2 years out is nearly $3.5 and if an investor would be willing to write a call option that long out and wait two years, the time premium would be his or hers. You may also note that the time premium declines fastest in the last month or two before expiry and so some option sellers only sell short term options in the hope of collecting this maximized time premium over and over again without triggering the exercise of the option. This seems to be especially true for options ITM or near the money (NTM).
Next we’ll be graphing intrinsic value.

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