Are You Buying The Right Options? These Four Areas Will Tell You…
Tuesday, August 18, 2009
by Karim Rahemtulla, Investment Director, Smart Profits Report
In last week’s issue, I covered the profitable and simplistic world of LEAPS trading - a simple way to trade, using long-term options that have an expiration date of one to three years.
And it’s this time component that is a critical factor when it comes to valuing the price of a LEAP option and the amount of risk involved.
An option’s price is determined by a computer program - either the Options Pricing Model or the Black-Scholes Model. Black, Scholes and Merton developed the latter model in the 1970s, winning a Nobel Prize for it.
Essentially, though, both models take the same main factors into account…
- The amount of time until expiration.
- The price of the underlying shares.
- The volatility of the share price.
- The risk-free rate of return.
Let’s take a look at these factors, so you know how to pick the right options with the best chance of yielding handsome profits…
Put Time On Your Side With LEAPS
~ Time To Expiration: When most people think about options, they think about getting the biggest bang for their buck and profiting in the shortest amount of time.
But be careful, because it isn’t that simple. With short-term options, time is against you. If the outcome you desire isn’t achieved within a short period of time, your option expires worthless.
However, LEAP options give you plenty of time for you to be correct and profit from the trade. Time is a critical component of a LEAPS trade.
For example, I’ve seen a LEAP option on a gold stock recommendation move from the $3 price we paid, to $0.50, then right back up to $16… all during a 12-month period.
Contrast that with a short-term option, which would have flamed out a long time before the share price recovered. With LEAPS, you have time to withstand a bad earnings report, a market correction, a terrorist attack, or a plethora of other shocks that would otherwise mean a world of hurt for your position.
Stock-Watching: How The Share Price Affects The Option Price
~ Price Of The Underlying Shares: It stands to reason that the price of the underlying shares is another key factor in determining how much you pay for the LEAPS options.
Basically, the closer the strike price (the price at which you have the right to buy or sell the stock) is to the current share price, the more expensive the option will be.
For example, if IBM (NYSE: IBM) trades for $100, a $95 call option would be considered in-the-money since the strike price is less than the current option price. In this case, the option premium will have intrinsic value. For example, if the option cost $9, $5 of that would be intrinsic value and $4 would be the amount paid for time and risk.
If your option is out-of-the-money, you pay for time and risk. So if IBM was at $100 and you bought a $105 call option for $5, the entire $5 would be for time and risk. But while the option premium is less than an in-the-money option, the probability of winning is also lower.
How Much Will Your Option Move? This Volatility Number Will Tell You
~ Volatility: When we talk about volatility here, we’re referring to how the share price performs in relation to the broader market. This is known as a stock’s beta.
Simply put, a stock with a beta of 1 will move in line with the market. A number under 1 means it’s less volatile, while a number higher than 1 means it’s more prone to volatility. So if the S&P 500 moves down 1% and your stock moves down 2%, your stock has a very high beta - double that of the market.
The higher the beta, the more expensive the options are, since options have the ability to move with greater speed in either direction.
For example, the beta on shares of tech giant Apple (Nasdaq: AAPL) will be much higher than the beta on a stodgy pharma company like Procter & Gamble (NYSE: PG).
~ Risk Free Rate Of Return: Measuring the cost of money at the cheapest possible price and the best possible return with no risk, this final factor is usually associated with government Treasury securities, especially 10-year Treasury Bonds.
Together, these four features - time to expiration, underlying share price, volatility, and risk free rate of return - represent the critical components in determining the price of LEAP options (or any options, for that matter).
Next time, we’ll explore the economics of the LEAP strategy along with how you can invest in the market with 15% of your cash while the rest of the world is foolishly using 100% of theirs.
Karim Rahemtulla
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