Time Value Again

A "call" option is the right to buy a stock at a set price known as the "strike price" or "exercise price." If the stock is worth $3 more than that strike/exercise price, the call option is worth that $3 difference, always. That's the intrinsic value of being able to save $3 when buying that stock. But, the option would be worth more than just that $3, as long as there is still some time left. If there is still a month to go, an ABC Aug 50 call might be trading for $4 a share, when ABC common stock is only trading for $53. The intrinsic value is $3, but there is still time for ABC to keep rising. If you want to buy this call option, you pay $4 a share, which is $3 of intrinsic value and $1 of time value. If the stock stops moving at $53, that time value will begin to evaporate quickly, as time runs out on the option. If you buy this option for $4 today, you can only win if the stock rises, and rises fast enough to outweigh the negative effects of time.

Let's work with the concept of time value in a rather annoying practice question:

Which option below has the most time value if ABC currently trades at $51 a share?
A. ABC Aug 50 call @$1.50
B. ABC Oct 50 call @2.50
C. ABC Oct 50 put @2.00
D. ABC Oct 55 put @4.25

EXPLANATION: step one, find the intrinsic value in each option and subtract that out of the premium. An Aug 50 call @1.50 has $1 of intrinsic value, 50 cents of time value. An Oct 50 call (which HAS to have more time value on it than the Aug 50) also has $1 of intrinsic value and, therefore, $1.50 of time value. Choice A is eliminated. An Oct 50 put has ZERO intrinsic value, so the time value is $2.00. Choice B is eliminated. An Oct 55 put has $4 of intrinsic value, so only 25 cents per share of time value. D is eliminated. The Answer is . . .









c

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

Options Question

We haven't done a practice question on options lately:

Your investor informs you that his market sentiment is currently "bullish-neutral." If the investor is not risk averse, you would most likely recommend that he
A. write call options
B. purchase call options
C. write put options
D. purchase put options

EXPLANATION: when you see "bullish" in the question, you can pretty well eliminate "A" and "D," which are bearish strategies. There is nothing "neutral" about purchasing a call option--you purchase a call only because you think the stock is going up in a hurry. If you write a put, you make money if the stock rises (bullish) or stays the same (neutral), which is why the answer is to write put options.
ANSWER: C

Options Question

Let's enjoy a really hard options question early on a Friday morning, shall we?

Johanna sold an Xyz Mar 50 call @3 and an Xyz Mar 50 put @2.25. Therefore, Johanna would profit if Xyz trades at all the following prices except:
A. 51.75
B. 55.25
C. 45.75
D. 53.00

First--what the heck is going on? Johanna sold/wrote a "straddle." She was willing to sell a call and sell a put with a strike price of $50 because she's convinced the stock won't move by very much up or down from $50. She's collected $5.25 per share. That means that she will make a profit if the stock fails to move up or down by $5.25 or more. At $51.75, the put expires worthless, and the call has an intrinsic value of just $1.75. She would make a nice profit of $350 at $51.75, so "A" is eliminated. At $45.75, the call expires, and the put is worth $4.25. She would make a small profit of $100 at that price, so "C" is eliminated. At $53 the put expires, and the call is worth $3. She makes a profit of $225 in that case. What about "B"? She breaks even at $55.25, which is not a profit, making the answer to the question . . . B.

Options Strategy

Not all options questions involve T-charts and calculations. Many have to do with strategy/suitability. The old what-should-the-pretend-investor-do-now questions are often the hardest of all, so let's have a little fun with one of these early on a Friday morning.

Dante purchased 100 shares of XYZ @44 several weeks ago. Now that XYZ last traded at $45, Dante is concerned that the stock has met resistance, and is, therefore, not likely to rise significantly. Therefore, you would recommend that Dante
A. buy 1 XYZ Oct 45 call
B. buy 1 XYZ Oct 40 put
C. sell 1 XYZ Oct 40 put
D. sell 1 XYZ Oct 50 call

Many students absolutely hate a question like that. Notice how it doesn't fit neatly into some magic options decoder chart, nor does it have anything to do with a memorized formula. You basically just have to think analytically. And, as usual, your job is to find something wrong with each of the recommended strategies so that you can eliminate three of them. We need to take the facts presented in the question and apply them first to "buy 1 XYZ Oct 45 call." Well, if Dante doesn't think the stock will rise, he would not want to buy a call. Call buyers are bullish; they think the stock is going up. Period. A is eliminated, then. What about "buy 1 XYZ Oct 40 put"? Is there anything in the fact pattern that says he expects the stock to plummet? No? So, he would not buy a put--B is eliminated. At this point many students want to choose "sell 1 XYZ Oct 40 put," but I'm not sure they really think through the strategy; instead, I think they just want the question to be over at this point. But, if Dante already owns the stock, he's at risk that it could drop. If he sells a put, he will get hurt twice if the stock drops. In other words, he'll lose money on the stock position, and he'll lose money on the short put for every dollar the stock drops. What about "sell 1 XYZ Oct 50 call"? At least this position is a hedge--a covered call. He's bullish on the stock; writing the call is bearish/neutral. In other words, it's not crystal clear whether he should sell the put or sell the call. But with analytical thinking and good test-taking skills, at this point you eliminate "sell 1 XYZ Oct 40 put" because there is something inherently wrong with a strategy that will double Dante's pain if the stock drops. And you're left with Choice D, the answer that was hardest to eliminate.

If you see a tough options question, post it in a comment.
Let's have some more fun with options, people. Heck, the weekend is nearly upon is.
BTW, today's Friday Free Broadcast is on "Rules and Regulations," which is key to the Series 7 and several other exams. Pull down the schedule at http://www.passthe7.com/ under Get Free Stuff.

How to approach options questions

Series 7 candidates often say curious things about options being "hard." Options are not "hard." Options are just freaking weird. When you first read about them, the terminology is confusing. Plus, most people can not for the life of them understand why anyone would actually engage in this sort of reckless activity. Believe it or not, the options exchanges were created in order to reduce the risk of a stock position. Seriously. Just as the commodities exchanges allow buyers and producers to pass off some of their price risk to another party, the options exchanges allow stock traders to pass off (hedge) some of their market risk to another party. But, for many traders, the key word here is "party." See, you can use an option to reduce the risk of a stock position. Or, you can just party or "speculate" as the professionals like to call it. When you buy and sell single options, straddles, or spreads, you are speculating on the short-term movement of a stock, index, or other "underlying instrument." Of course, most students don't like to drill down so hard on the concept of an option, but until you dig in and fully understand how options work, you will be one of those poor people trying to create the perfect chart that will act as some universal options question decoder.
Step one is to stop trying to create a magic chart and start trying to understand why a MSFT May 50 put is in- or out-of-the money and where to enter the intrinsic value in the little T-chart. Just keep it simple. A call is the right to buy something at a set price; a put is the right to sell something at a set price. You can buy those rights, or you can sell them. That is the whole story of options. Everything else involves your ability to break down the question.

Let's look at a question that is similar to what you'll see on the exam:

An investor buys an XRQ Oct 60 call @4 and an XRQ Oct 60 put @3. If XRQ is trading @54 at expiration and the investor closes both positions for their intrinsic value, what will be his gain or loss?
A. $700 loss
B. $700 gain
C. $100 loss
D. $600 gain

Keep it simple. He paid $7 a share total for this straddle, so the stock will have to rise by more than $7 or drop by more than $7 for him to gain. I like to know the breakeven points before solving the problem, because they provide excellent guidance. For example, I already know that if this stock can't make it above $67 or below $53, there is a loss here, not a gain. Do you see how knowing that will eliminate two answer choices? Two of the choices say "loss," while two say "gain"? So, did the stock go above $67 or below $53? No--so he has a loss. Eliminate the choices that have a "gain" in them. Answers "B" and "D" are gone--dismissed.
All right. You should probably use a T-chart here, although, really, at this point you can probably see that the loss is only $100. The stock only missed hitting the breakeven by $1, so he can't lose all $700. In fact, he could only have lost the full $700 if the stock had remained right at $60. And that makes sense, too--he's betting on volatility. By definition, if the market sits still, he's screwed.
But, again, using the T-chart is the fool-proof method. So, in your "debit" or "money out" column, you enter $400 for the call and $300 for the put that he purchased. Now, in your head you have to figure out what the "intrinsic value" of each option is now that the stock has dropped to $54. Many students struggle with this notion that the premium can, like, change. That's because they've never bought an option for $350 and then watched it drop to $10 in, like, an afternoon. Remember that as the stock is jumping around, so is the premium of the option. So, with the stock now trading at $54, the October 60 call is worthless--write a zero in the "money-in" side of the T-chart. The right to sell this stock at $60 would be worth exactly $6, so write "$600" in the money-in column, as well. Add it all up, and you see that he lost $100.

I'd say the dude got off easy, but who am I to judge? Maybe he has his reasons for risking $700 per contract speculating on volatility. To me, it seems a little weird. Like, maybe some counseling might be in order. But, again, it's not my job to judge. When I'm answering an options question, my job is to try to figure out what's going on and start eliminating wrong answers. If you can boost your score on options (derivatives), the pressure will come off on some of the other sections. Don't work on options exclusively, since they account for only about 38 of 250 exam questions. But, get these things down cold--it will boost your confidence big time. And, you can turn what is often a weakness into a strength with just a few extra hours of effort.