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What is an option and what gives it value? This week, we take a look at why options are insurance against financial uncertainty and why this insurance is often very reasonably priced.

Quick Basics

When you buy a call, you pay a premium for the right, but not the obligation, to buy a particular stock at a particular price, known as the strike price. When you buy a put, you pay a premium for the right, but not the obligation, to sell the stock at the strike price.

In Figure 1 below, we show an example of some call and put option premiums on Reuters. In our example, the stock price is $45 per share and the three strike prices are $40, $45 and $50. Looking at the calls, notice that the $40 strike has a total premium of $5.75. It has $5.00 worth of tangible or exercise value, since if you exercise it, you would be able to buy the stock at $40 and immediately sell it at $45. This call is said to be in-the-money. This option also has $0.75 worth of time premium. (This is the part of the option premium that is not tangible value.)

 

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The $45 strike call has a total premium of $2.25. It is said to be at-the-money. It is has no tangible value, but with the stock equal to the strike price, it has a time premium of $2.25. In fact, this is the highest time premium of all the strikes. The $50 strike call has no tangible value. It is said to be out-of-the-money, since you would not want to exercise it. It has a lower time premium of $0.65.

Looking at the puts, we see similar patterns. The in-the-money $50 strike put has a total premium of $5.65, of which $5.00 is tangible value (since you can buy the stock at $45 and exercise your right to sell it at $50) and $0.65 is time value. The at-the-money $45 strike put has the highest time premium of $2.25, while the out-of-the-money $40 strike put has no tangible value, and a time premium of $0.75.

Options as Insurance

Why do the at-the-money calls and puts have the highest time value, while both in- and out-of-the-money options have lower time values? And, why are the time values of the calls and the puts in this example the same for each strike price?

The answer has to do with the type of insurance that options offer. It is easy to understand that options come with insurance because you only have to exercise them if it is to your advantage to do so. But to fully understand the concept of options, you need to ask what are you really insuring against when you buy an option? Is it losing money? Yes, partly, but that is only part of the story.

Options also offer insurance against "opportunity loss." That is - they can insure you against missing out on profits if they occur. Often, doing nothing can be the worst course of action.

Thus, what options really insure you against is uncertainty - against being wrong after the fact. If you buy a call, you do not have to say, "I wish I had bought that stock, when l could have" or "I wish I hadn't bought that stock." If you buy a put, you do not have to say, "If only I had sold (or shorted) that stock," or, if you are hedging, "I wish I had held on to that stock."

Are Options Expensive?

Many people claim that options are prohibitively expensive, and sometimes they are. However, often they are fairly priced (or even underpriced) compared to reasonable expectations of how the stock is likely to perform. Therefore, they can offer surprisingly good value as insurance.

Let us use an example of hedging Reuters at $45, by buying the at-the-money put for $2.25. (Again, look at Figure 1.) Let's say that you hold the stock and are worried about where the stock might go. Based on past behavior, you think that a big move is possible. (The stock has traded as high as $50 and as low as $32 over the past 12 months.)

 

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With the at-the-money put, you are buying the maximum insurance. This is because you are buying insurance, with no deductible, against a big move in either direction.

It may surprise you to know that if an at-the-money option is fairly priced (i.e. the premium is in line with future volatility), there will be a 69% likelihood that the stock will end up outside the range of this premium paid. In the case of Reuters, it could move more than $2.25 to above $47.25, or down more than $2.25 to below $42.75. Either way, after the fact, you are likely to be glad you bought the option. In the graph on page 3, we show an example of this particular hedged position. The heavy bent line (and the left-hand scale) shows the gains (or losses) of the stock plus the hedge, while the curve with the drop lines (and the right-hand scale) shows the probability distribution. The area above $47.25 represents 35% of the possible outcomes, while the area below $42.75 represents 34%.

If the stock makes a big move in either direction, you will be happy you bought insurance. If Reuters goes to $60.00, you will have made a $12.75 profit ($15 less than the premium you paid). Alternatively, if the stock falls to $30, the put will offset the loss on the stock, so that all you will lose will be your $2.25 premium.

The Cheaper "Deductible"

But what if you are bullish on Reuters, but still feel that you need to insure against a really big loss? Or, what if you have turned extremely cautious on the stock, but do not want to miss out if the stock were to rise significantly? In either case, you may be willing to take a "deductible" on your time premium insurance.

For instance, if you are bullish and are willing to forgo some of your insurance on the downside (against cash losses), then you can take the "deductible" by buying the out-of-the-money $40 strike put for $0.75. The $5.00 difference between the stock and the strike price represents your deductible. That is how much you are willing to give up before your insurance kicks in. On the upside, your profits will be greater, because you have bought less insurance.

Alternatively, if you are very cautious about holding the stock, but don't want to fully discount the possibility of a large rise, you can take a deductible by hedging with the in-the-money put. By buying the in-the-money $50 put for $5.65, you have effectively taken a $5.00 deductible on possible gains. Remember that your time premium is only $0.65. At expiration, for all outcomes below $50, gains and losses in the stock and the option offset each other, so that all you will lose is the $0.65 time premium. If the stock goes from $45 to $60, you will have made $9.35, ($15 less your $5.65 premium).

Finding Fairly Priced Options

As we have often noted in these reports, there can be a lot more option buying opportunities than one might think. In our Option Screener, you can screen for underpriced options under Additional Option Information. Simply select as one of your criteria, Buyer's Under/Over Priced and specify a maximum of 0%. As of June 20, 2005, approximately 59% of all call and put asking prices were underpriced according to the Value Line option model's forecasts of future volatility.

To see other options strategy reprints, click here.