Options are valued (priced) based upon two components - the inherent value of the option itself and the time premium associated with the time risk of buying and selling options. For simplicity, I’ll discuss buying a call option. If a stock XYZ is selling at $42 per share and I wanted to buy a call option with a strike price of $40, the inherent value of the call option is $2 ($42-$40). If I could buy the option at $2 (the inherent value) then I would have the right, but not the obligation, to buy the underlying stock for $40 (the strike price) for a certain period of time (the expiration date). I would be controlling but not owning a $42 stock for $2.
As the underlying stock moved up in value the option would likewise have to move up in value because it’s inherent value increases with the increase in the price of the stock. I could essentially double my money with the simple move of the underlying stock of only $2 from $42 to $44. Simple enough to understand. Unfortunately the option would also fall in value as the underlying stock falls in price and would eventually be worthless (inherent value) if the underlying stock falls below $40 (the strike price). At this point I would have lost all of my money ($2). My protection is that I can only lose my $2 regardless how far the underlying stock drops in price because I’m not obligated to but the stock.
So far this all seems so simple. For a small amount of money I can control a large amount of stock. This is what leverage is all about. But this is not what the fun is all about in options trading. Options are not priced simply based on their inherent value (if they were, no one would sell them). They’re priced based upon their inherent value plus a small associated time value. It’s this time value (premium) associated with the buyer’s ability to leverage over time that creates the fun. It’s the idea that this time premium is limited and deteriorates over time is what motivates the seller as much as the leverage excites the buyer.
A call buyer will pay for both the inherent value as well as the time premium when buying an option. If I buy a call and the stock moves up, it’ll move right through this small time premium quickly. In the example above, if I paid $2.20 for the option and the underlying stock rose to $44, the option would be worth $4+ and I would have a $1.80+ increase on a $2.20 investment. That’s a 80+% increase instead of the 4.76% increase if I had just bought the underlying stock instead of the option. This is exactly what leverage will do for the trader.
What I’ve learned over the years is that the time premium associated with an option is the highest when the stock is priced at the option strike price. This premium will deteriorate as the underlying stock begins to move away from the strike price. Visually this is like seeing a bell curve in my head placed over the price of a stock at any given point. As the stock moves away from the center point the premium decreases continuously just like a bell curve. In addition, I visualize in my mind that same bell curve melting away as time passes. What’s happening is that both as the stock moves away from the strike price the premium is shrinking and as the stock move through time the premium is shrinking. That premium will continue to shrink so the option is really dependent on the movement of the underlying stock (it’s a derivative).
It’s that shrinking premium that’s working against the call buyer. He has to be right on the underlying stock’s direction because it’s so critical to his success. It’s the movement in the stock which will drive both the inherent value as well as offset the deteriorating time value.
Needless to say options begin to become exponentially more difficult to understand as you start to think about buying puts as well as selling both calls and puts. Sophisticated traders even do combinations of buying and selling both puts and calls simultaneously on the same underlying stock. I generally don’t do that. I like to keep my life simple.
For the most part I don’t buy options. I sell options. I like selling and collecting the time premiums associated with options. I feel that the odds are more in my favor selling options rather than buying them. I read somewhere sometime that most options expire worthless and most covered calls are sold by retirees trying to pick up some extra cash. Both of those ideas have stuck with me.
Options are a risky investment primarily due to their eventual expiration. It’s not recommended for beginner traders and most traders have to be approved by their brokerage house prior to being allowed to trade options. I was very cautious before I ever traded my first option. I read about 20 books on options trading and even then I only traded a couple of options. Even today I trade options with less than 10% of my portfolio because that’s all I’m prepared to lose in such a drastic way.
Options have been very good to me over the years and can be a strategic part of a trading plan. It has been part of my trading plan for years.