Understanding Time Premium - Part One
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, 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 call has a total premium of $5.75. It has $5.00 worth of tangible or exercise value. (That is if you exercise it, you can 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.)
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.”
To Be Continued...
This Article First Appeared in the Value Line Daily Options Survey – June 27, 2005
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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