How Options Can Turbocharge Your Portfolio
Options offer leverage. Using options, it’s possible to turn a small amount of initial investment into a significant sum of profit.
On rare occasions, options have been known to increase in value hundreds of times overnight when the conditions are just right.
Let’s say you are long a call option that expires in 3 days. It’s way out of the money and worth only $0.05.
But before the option expires, the company reports an incredible quarter with fantastic guidance and the stock rises 25% overnight.
The call option goes from $0.05 to $20. That’s a 400-fold gain overnight. If you had 10 contracts, the position would have jumped from a value of $5 to $2,000.
Of course, the knife can cut both ways. If you get caught on the wrong side without adequate hedging in place, you will probably get slammed.
The bottom line, though, is that options make greater moves (in percentage terms) than the stocks they track.
But you may notice that different options for the same stock react differently to the same price move. So how are options priced? What determines how much they move?
What Is Intrinsic Value?
The two components of an option price are the intrinsic value and time value.
The intrinsic value is the gross profit that the holder of the option would receive if he exercised the option now.
For a call, the intrinsic value is the stock price minus the strike price. For a put, it is the strike price minus the stock price.
If you have a $100 put option for stock XYZ, and XYZ’s market price is $95, the intrinsic value of the option would be $5. The option holder can buy XYZ on the market at $95 and sell the shares to the option writer at $100 for a $5 per share profit (ignoring transaction cost).
If XYZ’s market price was above $100, the put option would have no intrinsic value. This is because no one in his right mind would exercise the put and sell shares of XYZ for $100 when he could sell it for more on the open market.
What Is Time Value?
You will notice that generally an option price is higher than its intrinsic value. That difference—the premium—is the time value.
In general, the more time an option has left to expiration, the greater its time value.
This is because the more time there is, the higher the probability that an out-of-money option could end up in the money and an already in-the-money option could become even more profitable.
The time value falls over time because with each passing day there is less time for the option trade to work out in the buyer’s favor. The erosion in time value accelerates the closer the option gets to expiration. At expiration, the time value falls to zero so if the option is out of the money, then it’s worth nothing at expiration.
What is Implied Volatility?
Implied volatility can also affect the time value.
It is the estimated up and down of the underlying stock over the life of the option. A stock with high implied volatility will usually give its options a higher time premium because a stock that is expected to make big moves before option expiration is more likely to turn profitable for the buyer than one that hardly budges.
Short-term options will have less implied volatility than longer-term options of the same stock because there’s less time for the stock to make favorable moves.
Furthermore, options that are near the money will be most sensitive to implied volatility changes. When an option is near the money, there’s a greater chance that the intrinsic value could turn from zero to positive when the stock goes from out of the money to in the money or, in the opposite scenario, from in the money to out of the money.
This is why you will see different options of the same stock react differently to the move in the underlying stock.
Earlier I mentioned huge gain and loss. Those are extreme scenarios to make a point. Most option trades aren’t all or nothing. With proper risk management, option trading can be a steady profit generator.