Thursday, July 15, 2010

Don't Be Afraid of Options - Part 2: The Value of Time

In the first part of this series, I gave an introduction to how options work.  Let's now explore one of the main factors affecting the price of an option.

Your Biggest Enemy (or Friend) is Time
Let's go back to our Walmart example. If you click on "Options" on the Yahoo Finance page, you will see that the page lists out the options that expire in the current (or upcoming) month.  However, if you want to see the prices of the various options at a particular strike price, say $55 from our previous post, simply click on "55.00" and you will be brought to a page where all of the options at strike price $55 are shown (see Figure below).  As you can see, the price of the option increases as the expiry date increases.

If we think about it, it's very logical that this is the case.  Let's say we buy the July 2010 option of $55 strike price.  We only have the right to buy the stock at $55 until the 3rd Friday of July.  If we were to buy the January 2012 option, we have about a year and a half to exercise our option.  Since we have time on our side, chances are more likely that we'll be able to make money off this transaction.  Thus, people are willing to pay more for that option.

If you are a buyer of an option, time is your enemy.  Say you bought the Jan 2012 call @ $55 strike price option now.  It would cost you $2.70/share.  Fast forward 18 months and for some reason, Walmart's stock price hasn't changed a bit.  It's still sitting at around $50.  By this time, your option is about to expire, and with the share price being almost $5 below your strike price, nobody really wants to buy that option now, and so, it's close to being worthless.  So, the $2.70/share that you paid back in 2010 was what is called the time value.  You are paying for the prospect of being able to make money with the option.  There is no actual value in that option because the strike price was higher than the share price (i.e. if you were to exercise the option, you would actually be paying more than you would in the open market, which would obviously be stupid).

With an option, the longer you hold it, the more value it loses simply because time has elapsed.  However, with a plain share of stock, it would not lose value 10 years down the road; the share does not decrease value over time (effects of inflation aside).

If that's the case, it is understandable that time is our enemy.  So, how can you say that time is our friend when we're dealing with options?  It's simple...if the owner of an option loses as time elapses, then the person who sold him the option must be making money!  That's exactly the case.  Instead of buying an option, we can sell or "write" an option.  By writing an option, you are giving the right to buy shares of a stock at a specific price (for a call option) to someone else.  In return, they give you some money up front.

Understanding the writing of an option is a little bit more involved.  Let's leave that for our next post!