Judging the Put
Time works against all option buyers. Not only will your option expire within a few months, but time value will decline even if the stock's price does not change. Buyers need to offset lost time value with price movement that creates intrinsic value in its place.
You can select low-priced putsâones that are out of the moneyâbut that means you require many points of price movement to produce a profit. In other words, those puts are low-priced for a good reason. The likelihood of gain is lower than it is for higher-priced puts.
The problem is not limited to picking the right direction a stock's market value might change, although many novice options traders fall into the trap of believing that this is true. Rather, the degree of movement within a limited period of time must be adequate to produce profits that exceed premium cost and offset time value (and to cover trading costs on both sides of the transaction). This time-related problem exists for LEAPS puts as well. However, with much longer time involved, many put buyers view the normal market cycles as advantageous even when speculating. For example, you may need to spend more premium dollars to acquire a LEAPS put, but with up to three years until expiration, you will also have many more opportunities to realize a profit.
ExampleA Losing Proposition: You bought a put and paid a premium of 5. At the time, the stock's market value was 4 points below the striking price. It was 4 points in the money. (For calls, "in the money" means the stock's market value is higher than striking price, but the opposite for puts.) However, by expiration, the stock has risen 4.50 points and the option is worth only 0.50 ($50). The time value has disappeared and you sell on the day of expiration, losing $450.
ExampleTime Running Out: You bought a put several months ago, paying a premium of 0.50 ($50). At that time, the stock's market value was five points out of the money. By expiration, the stock's market value has declined 5.50 points, so that the put is 0.50 point in the money. When you bought the put, it had no intrinsic value and only 0.50 point of time value. At expiration, the time value is gone and there remains only 0.50 point of intrinsic value. Overall, the premium value has not changed; but no profit is possible because the stock's market value did not decline enough.
Smart Investor TipA bargain price might reflect either a bargain or a lack of value in the option. Sometimes, real bargains are found in higher-priced options.
ExampleFast Profits: You bought a put last week when it was in the money, paying a premium of 6. You believed the stock was overpriced and was likely to fall. Two days after your purchase, the stock's market value fell two points. You sold the put and received $800. This represents a return on your investment of 33.3 percent in two days (not considering trading costs).
ExampleKnow When to Quit: You bought a put last month, paying a premium of 4. At that time, you decided to set a few goals for yourself. First, you decided that if the put's value fell by 2 points, you would sell and accept a loss of $200. Second, you promised yourself that if the put's value rose by 3 points, you would sell and take a profit. You decided you would be willing to accept either a 50 percent loss or a 75 percent gain. And failing either of these outcomes, you decided you would hold the put until just before expiration and then sell for the premium value at that time.
ExampleMissed Opportunities: You bought a LEAPS put last month and paid 5. With 26 months to go before expiration, you thought there was plenty of time for a profit to materialize. Your plan was to sell if the value went up 2 points. A month after your purchase, the stock's market value fell and the put's value went up to 8, an increase of 3 points. You did not sell, however, because you thought the stock's market value might continue to fall. If that happened and the put's value increased, you did not want to lose out on future profits. But the following week, the stock's value rebounded 4 points, and the put followed, losing 4 points. The opportunity was lost. This pattern repeated several times and the put ended up worthless at the point of expiration.
Ask yourself: If you listen to that voice, when do you sell? The answer, of course, is that you can never sell. Whether your option is more valuable or less valuable, the voice tells you to wait and see. Lost opportunities are unlikely to repeat themselves, given the time factor associated with options; and even when those opportunities do reappear with a LEAPS put, it does not mean that the right decision will be made. The old stock market advice, "Buy in a rising market," cannot be applied to options, because options expire. Not only that, but time value declines, which means that profits you gain in intrinsic value could be offset if you wait too long. You need to take profits or cut losses at the right moment.
ExampleHesitateâand Lose: You bought a put last month for 6, and resolved that you would sell if its value rose or fell by two points. Two weeks ago, the stock's market value rose two points and the put declined to your bailout level of 4. You hesitated, hoping for a recovery. Today, the stock has risen a total of five points since you bought the put, which is now worth 1.
The problem of time value deterioration is the same problem experienced by call buyers. It does not matter whether price movement is required to go up (for call buyers) or down (for put buyers); time is the enemy, and price movement has to be adequate to offset time value as well as produce a profit through more intrinsic value. If you seek bargains several points away from the striking price, it is easy to overlook this reality. You need a substantial change in the stock's market value just to arrive at the price level where intrinsic value will begin to accumulate. The relationship between the underlying stock and time value premium is illustrated in Figure below .
ExampleGood Trend But Not Enough: You bought a LEAPS put for 5 with a striking price of 30, when the stock was at $32 per share. There were 22 months to go until expiration and the entire put premium was time value; you estimated that there was plenty of time for the price of the stock to fall, producing a profit. Between purchase date and expiration, the underlying stock falls to 27, which is 3 points in the money. At expiration, the put is worth 3, meaning you lose $200 upon sale of the put. Time value has evaporated. Even though you are 3 points in the money, it is not enough to match or beat your investment of $500.
[caption id="attachment_12468" align="aligncenter" width="340"] Diminishing time value of the put relative to the underlying stock.[/caption]
If you buy an in-the-money put and the underlying stock increases in value, you lose one point for each dollar of increase in the stock's market valueâas long as it remains in the moneyâand for each dollar lost in the stock's market value, your put gains a point in premium value. Once the stock's market value rises above striking price, there remains no intrinsic value; your put is out of the money and the premium value becomes less responsive to price movement in the underlying stock. While all of this is going on, time value is evaporating as well.
Smart Investor TipFor option buyers, profits are realized primarily when the option is in the money. Out-of-the-money options are poor candidates for appreciation, because time value rarely increases.
[caption id="attachment_12469" align="aligncenter" width="360"] Deep-in/deep-out stock prices for puts.[/caption]
To minimize your exposure to risk, limit your speculation to options on stocks whose market value is within five points of the striking price. In other words, if you buy out-of-the-money puts, avoid those that are deep out of the money. What might seem like a relatively small price gap can become quite large when you consider that all of the out-of-the-money premium is time value, and that no intrinsic value can be accumulated until your put goes in the money. Added to this problem is the time factor. As shown in Figure above, you may want to avoid speculating in puts that are either deep in the money or deep out of the money. Deep-in-the-money puts are going to be expensiveâone point for each dollar below striking price, plus time valueâand deep-out-of-the-money puts are too far from striking price to have any realistic chances for producing profits.