Financial Markets Book Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
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by Robert Hashemian

Page 292

$2 premium is entirely time value. As time passes and we get close to the option's expiration date (e.g. from 20 days to 3 days) and the stock hasn't budged from $50, the option's time value will decline to perhaps $1/4. Why? Simply because the stock now has five days to make this option profitable. With less time left to expiration, the option becomes riskier, hence the lower price. If the stock never gets past $50, the FAJ option becomes a total loss for its holders.

But let's look at the reward side of this. Suppose you bought the 2 FAJ contracts with 20 days to go at $2 per share for a total of $400 (Ford's stock trading at $50 at the time). If one day prior to expiration, Ford stock suddenly jumps to $52 3/8, your options will probably be worth $2 1/2 per share ($2 3/8 intrinsic + $1/8 time value for the one day left). You could sell the 2 contracts at $500 for a returned profit of 25% ($100 profit on a $400 original investment).Now if somebody else bought the same options 17 days after you did (now 3 days to expire) and Ford was still trading at $50, the risk would obviously be higher and those options would probably cost $1/4 per share. She could get those 2 contracts for $50. If Ford's stock made the jump to $52 3/8 with one day to go on the FAJ options, she would be able to sell those options for $500 (just like you did). Her profit would then be $450 for a total return of 900%!

Before you get too excited and sink your life savings into a risky option, let's see what happened here. The first trader (you) took a less risky path by buying the options 20 days from expiration. The second trader, however, made a riskier move and bought the same options with three days to go. In her case there was less time left for those options to become profitable. Ford's stock had 20 days to move up in order for your options to become profitable. Granted it would have had to move above $52 ($50 strike price + $2 you paid per share) in your case versus above $50 1/4 in her case, but you had 20 days to for this to happen.


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