by Andy Tanner
Since the stock is trading at $52 and you can buy at $50, your option has an intrinsic value of $2.
It makes sense that if you can buy at $50 and then sell at the current price of $52, you would earn a profit of $2. That brings up an interesting question: If the call option has a value of just $2, why then did you have to pay a premium of $5.80? The reason is that you are also getting five months of time to decide what you want to do. Time is money and it has value.
So when we buy an option we must consider its value on two fronts. The option might already have some intrinsic value, depending on the stock price and the strike price. Moreover, the option’s time value depends on how much time is left before its expiration date.
You can determine the time value of an option very easily. In our example, the premium was $5.80. Let’s figure out how much time value there is in this option.
In the chapter on fundamental analysis we concluded that price is what you pay and value is what you receive. If we pay $5.80 in premium and we know that $2 of what we paid was for the intrinsic value, then we know that the remaining $3.80 of the premium was for the five months in time value.
Time Decay
As the expiration date steadily creeps closer, the time value of the option will decrease, much like an ice cube melting in the sun. As a call-option buyer, you are anticipating a price move to the upside that will increase the intrinsic value of your option before time runs out.
Let’s continue with our example and see how things play out with intrinsic value increasing as time value decays.
The technical analysis on the chart shows a slight ascending triangle, followed by a nice breakout to the upside. You have taken a position with a call option contract that allows you to buy the stock at $50 anytime over the next five months.
A month passes and the stock is now standing at $61. You can still buy at $50, so the intrinsic value of the stock is now $11 per share. But there is less time before the expiration date, and the time value is therefore going to be lower. Notice that the value of the option reflects both the current intrinsic value of $11, and the reduced time value of $2.50, for a total premium of $13.50. Since the options market is liquid you could sell your option right now for a nice profit, but you still have plenty of time.
Now let’s move on. It’s five months until the option is close to its expiry date. The stock is now trading at $71, which gives your call option an intrinsic value of $21, since you still have the choice to buy the stock shares at $50. Notice that now there is very little time value left. In fact there is only 60 cents left in time value, since the option is about to expire. It’s time for you to sell your option.
You can now exchange that option (which means the same as selling it) through the Options Exchange. You have the option to buy that stock at $50, but you don’t want to actually hand over cash for the shares. Instead, you will now exchange that option electronically for its intrinsic value of $21.10 and time value of 60 cents. The final settlement price to exchange the option is $21.70.
Let’s review what happened during this trade.
•In October, the stock was at $52.50.
•By February it was at $71.10.
•If you had purchased 1,000 shares of the stock, it would have cost you $52,500 and you could have sold your shares in February for $71,100.
•Your profit would have been $19,100—a 36 percent profit in five months.
Or...
•You could have bought 10 call-option contracts, since one contract controls 100 shares of stock. That would have given you the choice to buy 1,000 shares of stock at $50 any time over the next five months. The option premium was $5.80, costing you a total of $5,800.
•You then exchange (sell) the option and receive a premium of $21,700 for the intrinsic value plus the small amount of remaining time value.
•Subtract what you initially paid for the option and then work out the rate of return:
(Money out – Money in) ÷ Money in
($21,700 - $5,800) ÷ $5,800 = 274 percent return
Paper Trading in a Virtual Account
As you learn more about trading options you can practice with paper trading, but don’t think that this exercise does not take advantage of our high-tech world and its tools. The term might sound old school, but you trade using a virtual account. By paper trading in a virtual account you can practice your fundamental and technical analysis skills with no risk (zero, zilch, nada, none...) because virtual accounts do not use real money. The value of these trades comes through practicing on real stocks in real market situations. As you trade, try different strategies side-by-side and get a sense of the risk and reward for each.
After doing your homework using fundamental and technical analysis, you can look at an investing situation and choose to leverage your money with options to grow it more rapidly than most of the people who invest directly in stocks. The key is the leverage you gain with options. When used correctly, it can help you far exceed what most people consider possible with personal investments.
Opportunities to Make Money When the Market Falls
Every asset class has its own benefits. One of the great advantages of paper assets is the agility they offer investors in positioning themselves to benefit from markets whether they go up or down. When large problems in the fundamentals begin to appear and critical technical levels in the charts begin to break down, many investors want to protect their wealth and also grow it by exploiting moves to the downside. As you continue to study and gain a greater appreciation for fundamental analysis, technical analysis, positioning for cash flow, and risk management, you will also find that you will be less concerned about which direction the market is headed and more concerned about how you are positioned.
The Put Option
The put option contract gives us leverage to protect ourselves or take advantage of downward moving stocks. We use the same principles and vocabulary as with call options. The only difference is the direction of the stock price.
Let’s go through a simple example of a put option. Suppose you’re looking at a stock that is currently trading at $100, and your fundamental and technical analysis leads you to think it will likely trend down for a few months.
The traditional way for an investor to take action in this situation is to short the stock. You could take a short position by borrowing 100 shares from the brokerage now and selling them for $100 each, giving you a total of $10,000. Sure enough, the company hits hard times just as the fundamentals suggested and the share price drops to $50. You can then buy your shares back for $5,000 and return the borrowed shares to the broker. Your profit is the difference between the price you sold the shares at and the price at which you subsequently bought back the shares: $5,000. But your risk was theoretically infinite since the shares could have shot right up through the ceiling. You would, of course, have had an exit strategy to prevent this, but on paper this is still an infinite risk. Is there another way to position yourself to profit from the downside and limit the risk? Yes—you could buy a put option.
Let say you buy a put option at a strike price of $100 and a premium of $3. In essence, this gives you the choice to sell 100 shares at the set price of $100 anytime between now and the expiration date. Just like a call option, you don’t need to own the stock. You just need to control the ability to sell it at a higher price.
So you take action and buy a put option on the stock. You now have the option to sell the stock at $100 per share. You have bought this option for a premium of $3 per share, which means you paid $300 for the option, and that is the only amount you risk losing. When the shares drop to $50, you buy 100 shares for a total of $5,000 and sell them with your option for the market price of $10,000.
You have made $5,000, less the cost of the premium of $300. Your reward is $4,700, and your risk was only $300.
As mentioned in Chapter Two, all asset classes have their own vocabulary. Part of your financial education is to become more familiar and fluent with the
language of money. In this chapter on positioning we introduced many new words that are now part of your financial lexicon.
Vocabulary Review
Call Option—After doing your fundamental and technical analysis, if you think a stock is likely to go up in value, you can buy a call option to gain more leverage. The call option means that you have a guaranteed opportunity to buy that stock at a set price called the strike price.
Put Option—If you think a stock is likely to drop, you can buy a put option for leverage. It gives you a chance to sell the stock at the strike price.
Strike Price—The purchase price of the stock agreed by the parties of the option agreement. A call option allows the owner of the option to buy the stock at that agreed price at any time before the expiration date for the option.
Premium—In order to buy an option, the buyer of the option agreement will pay the seller some money for the option. This is called a premium.
Option Chain—A table that includes all the essential information we need in order to make a choice on whether or not to enter into an option, including the expiration date, the strike price and the premium.
Intrinsic Value—The difference between the strike price and the actual value of the share price.
Time Value—The option premium less any intrinsic value.
Rate of Return—You can calculate your rate of return on any trade with a simple formula where Vf stands for Final Value and Vi stands for Initial Value: (Vf – Vi) ÷ Vi. You can then multiply this return by 100 to get your percentage return.
Remember to give yourself permission to learn new terms at your own pace, to review things more than once, and use the help of mentors to supplement your reading. Take the opportunity to solidify what you are learning by sharing it with others.
Once you know the basics of call and put options, you are ready to begin exploring how you can use these investment tools to generate a steady cash flow.
Getting an Income
Cash flow is about positioning. We want to make money if the market goes down; we want to make money if the market goes up; we want to make money if the market goes sideways.
There is no bad news in the market. There is only positioning. That’s a big idea to get your head around, I know. But let me make it simple: If gas goes up to $16 a gallon, is that good or bad? If you’re buying gas, it’s probably bad news. But if you’re selling gas, it’s probably good news. The value is in the eye of the beholder, and that is based on position. Is your position that of the buyer or the seller? You can’t control the market, but you can control your position. See the power?
Buy-and-hold investing, such as what you typically see with mutual funds and 401(k) plans, is usually an attempt to increase the value of an entire account through capital gains. When the market goes up, the account goes up. When the market goes down, the account goes down. That is not cash flow investing. Cash flow investing should offer:
•Proven strategies to extract cash from the market on one’s own timetable
•Ability to make profits at regular intervals
•Excellent rates of return
•Ways to manage the risk to protect capital
•Simple enough stategies for the average person to learn and implement on his or her own
Options and Time Decay
As we learned about the basics of options, we saw that one of the most important factors to consider was the amount of time until the option’s expiration date. As each minute passes between now and that expiration date, the total amount of time steadily diminishes until it ultimately reaches zero. As you will recall, this movement of time during the option’s life is called time decay.
Educated investors already know that time decay is an excellent opportunity to generate cash.
Real estate investors know that investment cash flow relies heavily on time decay. In the chapter on fundamental analysis we learned that by looking at financial statements we could determine the strength of an entity. Just as an option agreement has two parties, so does the rental or lease agreement. You can evaluate the financial statement for each of the two parties. In doing so you can determine which of the two parties is most likely to become rich.
Let’s look at the financial statements of each party to a common lease agreement and make some observations:
Let’s suppose that you are a landlord who owns a house. I need to find a place to live, and your house looks very nice. You agree to lease me the house in exchange for regular monthly rent payments. For me, our lease agreement is a liability because I must pay you a monthly rent amount. On my income statement, it is shown as an expense, since money flows out of my account. I am not buying the house from you, I’m simply buying time. When I give you the rent check, you agree to allow me to live there for a certain amount of time. At the beginning of the month I might pay $1,000. But that money only buys me a month of time. When that time expires, I have nothing left.
On the other hand, you are now receiving income because of the lease agreement. You are earning money on the movement of time. It doesn’t matter if the value of the house increases or decreases. All that concerns you is that you are receiving income. With time decay, the seller of the lease receives income independent of the underlying value of the asset.
With options, the time decay is somewhat similar to this example. Just like a lease agreement, options have expiration dates. When you buy an option for three months, the premium (think of it as time value) is at its highest due to the large amount of time remaining until expiration. The premium is lower for a two-month option because there is less time available to buy. For a one-month option, the premium is even lower because the time is quickly running out.
You can see time decay has the look of an exponential graph rather than a linear graph. More simply stated, you can see here that the closer an option gets to its expiration date, the faster it loses time value. When buying an option, an investor typically wants plenty of time remaining. This allows the intrinsic value to increase as the time value diminishes. As a general rule of thumb, I usually want two months or more until expiration so that there is plenty of time for that intrinsic value to rise.
However, when it’s time to sell an option, I typically want to sell it closer to expiration and book my profits because there is not as much time for the intrinsic value to increase much more, and the time value decay is much faster.
The illustration above of a three-month option shows this concept very clearly. From three months remaining to two months remaining, we lose very little value due to time decay. From two months to one month, a bit more of the value is whittled away. But look at what happens in the last month, also called the front month, when the option expires. The option rapidly loses all its value through time decay as that expiration approaches.
Frequently, naïve option investors make a critical mistake I want to help you avoid. When they look at an option premium during the front month, they often see how inexpensive it is and think it’s a good time to buy. As I explained before, the closer you get to expiration, the less time there is for the intrinsic value to increase. Which means you are flirting with the risk of having your option expire worthless because it didn’t increase in value for you.
One of the things that makes options different from stocks is that options expire. So you must not forget the importance of time when you take a position of leverage. The following example looks good on paper, but this leveraged position does not give the investor much time.
The last price for ACME is $250 per share. An investor looking at this stock realizes that to buy one thousand shares of ACME would require $250,000. Then that investor looks at the option chain and sees that a call option is just $5 a share. By comparison, the investor can control the same 1,000 shares of stock for just $5,000 of option premium.
On the surface, this looks like a very attractive investment opportunity. The difference is, of course, that when you buy the stock directly there is no time limit on how long you c
an hold that stock as you wait for it to gain in value. With the option, that expiration date is very near. Given such a limited amount of time, it’s difficult to imagine that the underlying stock price will rise enough to give you a good return on your investment. Moreover, if the stock were to fall even slightly, then the option would expire worthless and all of the premium would be lost.
In this case, the seller of the option came out with a great profit and the buyer was the loser.
Cash Flow vs Speculation
Let’s revisit the situation with real estate investing to help us get a clear picture of how you might find cash flow investing more suitable to you than mere speculation that the value of the overall investment will increase over an extended period of time. For this example, we’ll look at the numbers behind buying a house with a mortgage and then renting it to a tenant.
You originally bought this house for $285,000 and took out a mortgage for $215,000. Your mortgage repayment is $1,500 a month. The tenant in your property is paying you rent of $2,000 a month, giving you a positive cash flow of $500 per month.
Of course, the actual market value of your house can go up or down depending on economic conditions. For this scenario, suppose that the recent negative economy causes the value of your house to drop to $235,000. Instantly, your home has decreased in value by $50,000 because of market conditions beyond your control. However, you are still obligated to pay the $1,500 monthly mortgage payment. Likewise, your tenant still pays you $2,000 per month for rent. And you still have positive monthly cash flow of $500. No matter what happens with the value of the house, you are still entitled to the rent. The deposits to your bank account from collecting rent will continue regardless of the price fluctuations of your rental property.
