c12 JWBT016-Busby September 30, 2008 14:21 Printer: TBD
130 STRATEGIES TO WIN
As noted above, the option premium or cost of the option is made of
intrinsic value and time value. If GE is trading at $36 per share, the October
35 call is 2. The intrinsic value is $1 and the time value is $1. Remember that
the intrinsic value is the amount of money a contract is in the money. The
intrinsic value is equal to the share price ($36) less the strike price ($35).
In this example the intrinsic value is $1.
Time value is the amount of money a contract is out of the money. The
time value is the premium less the intrinsic value.
There is one final factor that will affect option price and that is volatil-
ity. The volatility of the underlying security is important. The more volatile
the underlying security, the higher the premium will be. Likewise, the less
volatile the underlying security is, the lower the premium will be.Options Logic and Risk
When buying a call option, you pay a premium. For that premium, you gain
the right to buy the underlying security at the set price when and if the
strike price is hit. The maximum risk or amount of money that you can
lose is the price of the premium. When buying a call, the assumption is that
the stock price will rise. It is best to go long calls 60 to 45 days out from
expiration to avoid time decay. As with buying a call, if you buy a put, the
maximum exposure is the cost of the premium. Also, as with buying a call,
I recommend only going out 60 to 45 days when buying a put.
Going short a call without owning the underlying security is a far
riskier proposition. This is known as selling naked calls. If the strike price
is hit, you will be forced to sell the security at the strike price and deliver
it to the purchaser of the option. The risk is unlimited.
When buying a call option, the buyer pays the seller the premium.
When shorting a call, the seller receives the premium. If the strike price
is not hit, the seller keeps the premium.
Time decay is a friend to the seller of call options. The seller does not
want the call to get to the strike price. It is best to sell call options 30 to
45 days out from expiration and hold them until expiration in order to keep
the premium. Going short a put without being short the underlying security
is selling a naked put. Like shorting stock, the upside risk can be substan-
tial. When selling a put option, the seller assumes the underlying security
will move higher. When purchasing a put option, the buyer pays the seller
the premium. When shorting a put option, the seller receives the premium.
As long as the underlying security does not get to or exceed the strike price,
the seller gets to keep the premium. Time decay is a friend to the seller of
the put option. The seller does not want the put to get to the strike price. It