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 puts—ones that are out of the money—but 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.

When you buy in-the-money puts, you will experience a point-for-point change in intrinsic value; but that can happen in either direction. For put buyers, a downward movement in the stock's market value is offset point for point with gains in the put's premium; but each upward movement in the stock's market value is also offset, by a decline in the put's intrinsic value.

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.


Example

A 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.


Example

Time 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.

Whether using listed options or LEAPS to buy puts, it remains a speculative move to go long when time value is involved. Some speculators attempt to bargain hunt in the options market. The belief is that it is always better to pick up a cheap option than to put more money into a high-priced one. This is not always the case; cheap options are cheap because they are not necessarily good bargains, and this is widely recognized by the market overall. The question of quality has to be remembered at all times when you are choosing options and comparing prices. The idea of value is constantly being adjusted for information about the underlying stock, but these adjustments are obscured by the double effect of (1) time to go until expiration and the effect on time value, and (2) distance between current market value of the stock and the striking price of the option. When the market value of the stock is close to the striking price, it creates a situation in which profits (or losses) can materialize rapidly. At such times, the proximity between market and striking price will also be reflected in option premium. It's true that lower-priced puts require much less price movement to produce profits; but these low-priced puts remain long shots.

Smart Investor Tip

A bargain price might reflect either a bargain or a lack of value in the option. Sometimes, real bargains are found in higher-priced options.


Example

Fast 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).

In this example, you turned the position around rapidly and walked away with a profit. So the bargain existed in this put because you were right. The return was substantial, but that does not mean that the experience can be repeated consistently. Remember, when you buy puts on speculation, you are gambling that you are right about short-term price changes. You might be right about the general trend in a stock but not have enough time for your prediction to become true before expiration. With this in mind, it is crucial to set goals for yourself, knowing in advance when you will sell a put—based on profit goals as well as loss bailout points.

Example

Know 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.

Setting goals is the only way to succeed if you plan to speculate by buying options. Too many speculators fall into a no-win trap because they program themselves to lose; they do not set standards, so they do not know when or how to make smart decisions.

Example

Missed 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.

This example demonstrates the absolute need for firm goals. Even with a lot of time, you cannot expect to realize a profit unless you also know when to close the position. Inexperienced option speculators do not recognize the need to take profits when they are there, or to cut losses—either decision based upon a predetermined standard. When the put becomes more valuable, human nature tells us, "I could make even more money if I wait." When the put's value falls, the same voice says, "I can't sell now. I have to get back to where I started."

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.

Example

Hesitate—and 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.

In this example, you would lose $300 by not following your own standard and bailing out at 4. Even if the stock did fall later on, time would work against you. The longer it takes for a turnaround in the price of the underlying stock, the more time value loss you need to overcome. The stock might fall a point or two over a three-month period, so that you merely trade time value for intrinsic value, with the net effect of zero; it is even likely that the overall premium value will decline if intrinsic value is not enough to offset the lost time value.

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 .

Example

Good 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.

The farther out of the money, the cheaper the premium for the option—and the lower the potential to ever realize a profit. Even using LEAPS and depending on longer time spans, you have to accept the reality: The current time value premium reflects the time until expiration, so you will pay more time value premium for longer-term puts. That means you have to overcome more points to replace time value with intrinsic value.

[caption id="attachment_12468" align="aligncenter" width="340"]Diminishing time value of the put relative to the underlying stock. 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 value—as long as it remains in the money—and 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 Tip

For 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.

Whether you prefer lower-premium, out-of-the-money puts or higher-premium in-the-money puts, always be keenly aware of the point gap between the stock's current market value and striking price of the put. The further out of the money, the less likely it is that your put will produce a profit.

[caption id="attachment_12469" align="aligncenter" width="360"]Deep-in/deep-out stock prices for puts. 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 expensive—one point for each dollar below striking price, plus time value—and deep-out-of-the-money puts are too far from striking price to have any realistic chances for producing profits.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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