Option Selection for the Beginner
What Is a Cheap Option?
Each of us has our own idea about when something is cheap. On a superficial level, something that costs $1 is cheap, and something that costs $100 is expensive. But it is not really the dollar cost that makes something cheap or expensive. Rather, it is whether the intrinsic value of the item purchased is close to the cost paid to own that item. Often, we are tempted to buy something at a price which has been "hyped" way beyond its intrinsic value. Remember the Beanie Baby craze of a few years ago, when those cute little stuffed animals were being hyped as collector’s items and as such were being bought for way more than their intrinsic value? Now that the craze has passed, these items are being sold at garage sales for a price that is much closer to their intrinsic value. The hype value of the Beanie Baby has disappeared over time.
What does this have to do with options? Well, every option has a price that represents its intrinsic value plus a hyped value. In the language of option traders, the hyped value of the option is called its time value. We are all familiar with the cliché "time is money," and never was this expression truer than as it applies to the price of an option. Options are time-limited financial instruments, and it makes sense that an option with a life of five months should cost more than an option with only one month of life. With any option, you do not want to pay for too much time value. One situation that warrants caution is when a stock is generating lots of excitement (good or bad), because the price of its options will be hyped up with extra time value.
Whenever you consider buying an option, it is a good idea to identify just how much of its price is intrinsic value and how much is time value. It is easy to compute its intrinsic value by asking this question: What would this option be worth if it expired immediately today? When that intrinsic value is deducted from the full option price, the remainder is the time value.
Let's look at a couple of examples:
Example 1. In mid-November, XYZ stock is at $89. The December 85 call gives you the right to purchase 100 shares of XYZ stock at $85 per share at anytime before this option expires in about four weeks. The asking price for this call is $4.50 per share. How much of this price is intrinsic value and how much is time value?
Example 2. Again, XYZ is at $89 in mid-November. The December 90 call is priced at $1.50 per share. How much of this price is intrinsic value and how much is time value?
If this option were to expire as you are looking at it, you could exercise your right to buy XYZ at $85 and then sell it at the current market price of $89 for a profit of $4. So, the December 85 call has an intrinsic value of $4 per share. The rest of the price of the option is its time value, which in this example is $.50 per share [4.50 4.00 = .50].
Compare the December 85 call priced at $4.50 per share with the April 85 call priced at $7.50 per share. The intrinsic value is still $4, but for the April option, the time value has increased to $3.50 per share [7.5 4.0 = 3.5]. This illustrates that "time is money" because you will have to pay $3.50 per share to control this stock for five months as compared with $.50 per share to control it for four weeks.
If this option were to expire as you are looking at it, it would be worthless. The right to buy XYZ for $90 per share is worthless when the stock can be bought in the open market for $89 per share. So, the December 90 call has an intrinsic value of $0. The rest of the price of the option is time value, which in this case is the total price of $1.50. If XYZ does not go up during the four weeks before the December 90 call expires, the value of this option will shrink to $0.
Now, let's get back to the original question: What is a cheap option? The XYZ December 85 call is $4.50 per share, while the December 90 call is only $1.50 per share. Is the December 90 call really cheaper? If we just consider time value, the December 90 call is three times more expensive than the December 85 call ($1.50 versus $.50). Of course, if XYZ is going to $95 before the December expiration in four weeks, you will have a much larger percentage profit if you bought the December 90 call. But suppose XYZ only edges up to $91 at the December expiration. The December 90 call would be worth $1 and you would have a loss of $.50 per share [1.00 1.50 = .50]. Compare that with the December 85 call, which would be worth $6, and you would have a profit of $1.50 per share [6.00 4.50 = 1.50].
The objective of this discussion is to start you thinking about intrinsic value and time value when you look at an option price. When you buy an option, you are almost always going to be paying for some time value—it is the nature of the beast. Just remember that for your option to make a profit, the stock price must move enough to overcome the loss of some if not all of that time value. The preceding examples demonstrate that the option with the lowest price is not always the best bargain.
Let’s continue with the thought process that you should develop in selecting a particular call option or put option to buy. We will assume that you have identified a stock, which you think is going to make a move in price (either up or down). To play this expected move in the stock price, you decide to use options to achieve more leverage for profit. Now you need to determine which option is going to work best.
To select the best option, you need to examine various choices to arrive at a proper decision. In the following illustrations, we focus on the case in which the stock price is expected to go up and hence we want to buy a call option. At the end, you learn how a similar analysis can be applied to the case of buying a put when the stock price is expected to go down.
In the context of buying a call, three example choices are presented. For each example, we follow several scenarios to see whether the outcome is compatible with our expectations. The three examples do not cover every possible situation, but they should provide enough illustration for you to begin developing your own skills at analyzing outcomes.