Time Value

The Smart Profits Report: Issue #110
Friday, May 14, 2004

Time Value: With Options You Need to Be Right on Time
By Karim Rahemtulla
Chairman, Mt. Vernon Research

We’ve all heard the cliché a thousand times, but in options, “time is money” - literally. In fact, when you buy an option, what you’re paying for is time or time value.

Some months ago I made a quick trade with puts on Martha Stewart Omnimedia. Once I knew the jury in the Martha trial was likely to announce its verdict on her guilt or innocence within hours, I bought the puts that were set to expire in two weeks.

That may sound as if I gave myself plenty of time. In theory, my puts were good for two weeks… but had the jury been hung or the verdict delayed for any reason, my two-week options would have lost their value as fast as a Popsicle in July.

The puts I bought for 25 cents could have dropped to 10 cents in a day, being that close to expiration. Worse, if the jury had dawdled, other investors would probably have taken it as a good sign and the stock might have nudged up a bit before it fell. And my puts would have been worth zero.

Options Pay Off: Moving Before Time Value Evaporates

When you are betting on the direction of a stock/commodity/futures price, and using an option, then that underlying vehicle has to move within that time frame. That is what options are all about - not just being right, but being right in time. For an option to pay off, the stock has to make a significant move faster than time value evaporates. That is the hook, the bait, the lure. And to add to the challenge, the closer an option gets to expiration, the more quickly its time value declines.

It makes perfect sense. If the market lets you bet a penny instead of a dollar and offers big rewards with leverage, too, there has to be a downside somewhere. The downside is time. It’s the great leveler in options.

Give Yourself Enough Time, Or Else…

Here’s my take on short-term options - by that I mean ones that expire in a month or two. If you trade short-term options and you don’t have a system, then you are betting that Nostradamus was one of your ancestors - and his genes are dominant in your gene pool.

When you bet on a short-term option, you are saying to the world, “Look, I can predict the future!” If you really can predict the future, please contact me ASAP and I will put you on our payroll with a six-figure-no make that seven figure-salary. If you are normal and cannot predict the future, then read on.

The good news is that there are many types of options. Some expire in a month, some three months, some in a year and some in three years. The more time value you have on an option, the more expensive it will be. (For example, GE is currently trading at $30 levels, and its January 2006 $15 calls are trading at more than $15.)

Again, this is just logical. If you have more time value, then that’s just more time for things to go your way. You will be less affected by the underlying stock’s normal up and down moves when they go against you.

I prefer to use a strategy that gives me more time for something to go my way. I can’t predict what will happen next week or next month, but I can make an educated guess about what may happen in a year or two. And, with a long-dated option, like a LEAP option, I can withstand a lot of temporary shocks in the market or a stock.

Almost As Good as a Crystal Ball: Long-Term Options

For instance, back before the war in Iraq, we had a few two-year options in Duke Energy (NYSE: DUK). We bought the January 2005 $15 calls on February 20, 2003.

When the war began, the options went down, along with the underlying stocks. Short-term traders with calls got brutalized. But my long-term options were safe. More than safe, in fact. Because as soon as we recognized victory, about three months into the war, the reaction in the United States was ebullient. The stock market took off… and so did our options.

We wound up selling on August 4, 2003, pocketing a nice 83% return. Compare that to the fate of the short-term trader. If he bought a call, even on a great stock, just a month or two prior to the war, he took a huge risk. The longer the market waited for war to start, the worse stocks did.

Gloom & Doom Spreads To All Stocks

The gloom spreads to weak and strong stocks alike. No one knew just when the war would begin, so those short-term traders were really spitting in the wind. They had no idea when the market might stop going against them, and whether to hold on or bail out. They watched their calls became worthless in a hurry. Even if they were right in the long run, they failed to give themselves long enough to run, time value was working against them.

A thousand things and events affect stocks and the market as a whole every day-it could be waiting for war, it could be news of fraud at a competitor, an employment report, a better-than-expected GDP report.

Give your options enough time value for the effect of these ancillary events to work out and your chances of being right about where your stock (and ultimately your option) is headed improves dramatically.

Here’s to good times - and profits - ahead.

Good Trading,

Karim Rahemtulla