Time Value

Remember, not all Series 7 questions concerning options involve calculations or even numbers. Many of the tougher options questions look like the one below:

Which of the following represents an accurate statement about put options on ABC common stock?
A. If ABC common stock drops from $45 to $40, an ABC Aug 40 put goes in the money
B. If ABC common stock drops from $45 to $40, the premium on an ABC Aug 40 put would likely increase
C. If ABC common stock drops from $45 to $40, an ABC Aug 40 put goes out of the money
D. If ABC common stock rises from $35 to $40, the ABC Aug 40 put premiums should increase

EXPLANATION: as always, try to eliminate some answer choices. Choice A says that an ABC Aug 40 put would be in the money with the stock at $40. That makes no sense, so eliminate it. Choice C says that an ABC Aug 40 put would be out-of-the-money with the stock at $40, but, actually, it would be at-the-money. Choice D says that put premiums increase when the stock price rises, but that's backwards. Strike prices are fixed--the puts only become more valuable as the underlying stock drops, making the right to sell it more valuable. Eliminate Choice D, and you're done. Why is Choice B accurate? Remember that even though the ABC Aug 40 put would not go in the money if the stock dropped from $45 to $40, the "time value" would increase, the speculative component of the premium. With the stock at $45, the right to sell it at $40 is not worth much, but if the stock then drops to $40, the market would assume it could easily keep dropping, and any little drop makes the put go in-the-money. The premium would reflect the 50-50 chance that the option will go in-the-money, and, of course, the premium would be 100% time value. So, a seller might like to write an at-the-money option, and then if the stock simply stops moving, that time value will evaporate, letting the seller keep the whole premium without lifting a finger as the option expires.



ANSWER: b