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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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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