Judging Whether You Can Profit From A Put Option, Part 1
Posted by Goody on 02/20/08 in Education, Finance
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.
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.
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.
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.
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