One of two things needs to happen in this situation. Either the stock’s current market value needs to rise quickly so that your call premium will be greater than the 5 you paid, or the stock’s market value has to rise enough points by expiration to offset time value (3 points) plus grow beyond the intrinsic value level.
This shows how option buyers need to evaluate risk. In the example, time value represents three-fifths of the total premium. If expiration comes up quickly, the stock will need to increase significantly in a short period of time to produce a profit. In thinking about whether it makes sense to buy such a call, consider these alternatives, especially if you believe that the stock will rise in value:
· Buy 100 shares of the stock. If you believe it has potential to increase in value, owning the shares without the built-in deadline of expiration makes ownership more desirable. The added problem of time value could translate to making outright stock purchase not only safer, but more profitable as well.
· Sell a put instead of buying a call. Put sellers have limited exposure compared to call sellers; and if the stock’s market price rises, the entire premium will represent profit. Compared to buying a call, the selling of a put often is an overlooked strategy that could make a lot of sense. If you decide to sell a put, your brokerage firm will require you to deposit cash as a reserve in case of exercise, to ensure the money is available to pay for the stock. Going short is a higher-level strategy too, so your brokerage firm may take a harder look at you and your qualifications to engage in short option strategies.
A third opportunity could present itself in taking the opposite approach to buying. Given the previous example, in which significant increase in value would be required to make a profit, it might be viewed as an opportunity to sell a call instead of buying one—as long as you remember the higher risks that are involved. Selling uncovered calls is one of the highest-risk strategies you can use; risk is unlimited, at least in theory. So if you take this route, you will be assuming a much greater risk profile. Call sellers benefit from decline in time value; but uncovered short sales are the highest-risk strategies so, even with attractive profit possibilities, the risks cannot be ignored.
Example: Turning the Tables: Given the same circumstances as those in the previous example, you decide to sell a call instead of buying one. Instead of paying the $500 premium, you receive $500 as a seller. Of this, $300 represents time value, which now is an advantage rather than a problem. The possibility of expiration is an advantage as well. The pending expiration places pressure for time value to evaporate, meaning greater profits for you as a seller. As long as the stock’s current market value does not increase more than three points between now and expiration, the transaction will be profitable. However, because the call is in the money, you also face the possibility of exercise. The two points of intrinsic value have to be weighed against the five points you receive for the call to make a value judgment about this strategy; in addition, your trading costs have to be factored into the calculation.
By the time of expiration, all of the time value will have disappeared from the premium, and all remaining premium will represent intrinsic value only. To avoid exercise, you would want to buy to close the call and take the $300 profit; however, exercise can occur at any time, so in this position you remain exposed to that possibility. When no time value remains at expiration, the condition is known as parity.
Get your Momentum Stock Trading System and sign up for my free weekly online trading system newsletter here at: http://www.stressfreetrading.com
Tags: fiance, investing, stocks, trading
