Let's Talk About Time Decay - Part Two: Options As Insurance
OPTIONS AS INSURANCE
Whydo the at-the-money calls and puts have the highest time value, whileboth in- and out-of-the-money options have lower time values? And, whyare the time values of the calls and the puts in this example the samefor each strike price?
The answer has to do with the type ofinsurance that options offer. It is easy to understand that optionscome with insurance because you only have to exercise them if it is toyour advantage to do so.
But to fully understand the concept ofoptions, you need to ask what are you really insuring against when youbuy an option? Is it losing money? Yes, partly, but that is only partof the story.
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OPPORTUNITY LOSS
Options also offer insurance againstìopportunity loss.î That is - they can insure you against missing outon profits if they occur. Often, doing nothing can be the worst courseof action.
Thus, what options really insure you against isuncertainty - against being wrong after the fact. If you buy a call,you do not have to say, ìI wish I had bought that stock, when l couldhaveî or ìI wish I hadnít bought that stock.î
If you buy a put, you donot have to say, ìIf only I had sold (or shorted) that stock,î or, ifyou are hedging, ìI wish I had held on to that stock.î
To Be Continued In "Part Three: Are Options Expensive?"...
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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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