Let's Talk About Time Decay Part Three: Are Options Expensive?
...continued from Part Two
ARE OPTIONS EXPENSIVE?
Manypeople claim that options are prohibitively expensive, and sometimesthey are right. However, often they are fairly priced (or evenunderpriced) compared to reasonable expectations of how the stock islikely to perform. Therefore, they can offer surprisingly good value asinsurance.
Let’s use an example of hedging Reuters at $45, by buying the at-the-money put for $2.25. (Again, look at Figure 1.)Letís say that you hold the stock and are worried about where the stockmight go. Based on past behavior, you think that a big move ispossible. (The stock has traded as high as $50 and as low as $32 overthe past 12 months.)
With the at-the-money put, you are buyingthe maximum insurance. This is because you are buying insurance, withno deductible, against a big move in either direction.
It maysurprise 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 a69% likelihood that the stock will end up outside the range of thispremium paid.
In the case of Reuters, it could move more than $2.25 toabove $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.
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SEEING IS BELIEVING
This GRAPH providesa visual example of how this particular hedged position performs. Theheavy 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 (andthe right-hand scale) shows the probability distribution. The areaabove $47.25 represents 35% of the possible outcomes, while the areabelow $42.75 represents 34%.
If the stock makes a big move ineither direction, you will be happy you bought insurance. If Reutersgoes to $60.00, you will have made a $12.75 profit ($15 less than thepremium you paid). Alternatively, if the stock falls to $30, the putwill offset the loss on the stock, so that all you will lose will beyour $2.25 premium.
To Be Continued In Part Four...
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