Saturday, July 10, 2010

Time Value Once Again

On our Facebook fan page, we asked visitors which option would trade for a higher premium here in July: MSFT Aug 30 call or MSFT Oct 30 call. At first, it might seem that you need more information . . . well, what is the underlying stock trading for?

Doesn't matter.


No matter what MSFT common stock is trading for, the time value is higher on the Oct 30 call. Why? Because--get this--there is more time on the option. See, the premium is the market's collective opinion on the buyer's chance of winning. Period. The market as a collective is so efficient at assigning a value based on probabilities, in fact, that right after the Sep 11th attacks, the US Government actually floated the idea of creating a "terrorism exchange" on which speculators would bet on where the next attack might occur. Maybe they realized how sick the temptation for market manipulation would have been--go long the Los Angeles Mar 15s and then pay some sickos to blow up LAX--or maybe their sanity suddenly returned. Either way, they did not actually create such an exchange, thankfully, as it would have been, you know, crazy. Still, their premise was correct--a market of speculators is very good at determining a fair price for an option based on its probability of working out for the buyer. If the underlying stock trades at $29, an Aug 30 call is worth more than an Aug 35 call, even though both are out-of-the-money. Why aren't they both worth 0? Because there is a chance the stock can rise above $30 before expiration, and a chance it could rise above $35. Which chance is more likely? Obviously, the Aug 30 call has a more realistic chance of going in-the-money, so its time value is higher than the Aug 35 option. If it's early July, maybe the Aug 30 calls trade for $1.50, with the Aug 35 calls trading at just $.45. It actually depends on how volatile the stock is. If it's the kind of stock that jumps around all the time, the market might charge you $2.00 even for the Aug 35 call. The market is saying the stock could easily rise that high that fast. Google options trade at high premiums, because that stock can easily rise or fall $20 in a week. Microsoft, on the other hand, is so sluggish and predictable that the options are cheap. The market basically says no way is MSFT going up $10 any time soon. You can buy these options dirt cheap.

So, what determines the premium of a call option?

1. the market price of the underlying stock

2. the amount of time left on the option

3. the volatility of the underlying stock

An army of computer-modeling, big-brain speculators plug those factors into their software and, voila, an options premium becomes X, Y, or Z. I know it hurts to think this hard about the concept of an option. But, trust me, your score will go up if you understand options well beyond any little chart or cheat-sheet.

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