Let's Talk About Time Decay - Part Four: The Cheaper Deductible
THE CHEAPER "DEDUCTIBLE"
Butwhat if you are bullish on Reuters, but still feel that you need toinsure against a really big loss? Or, what if you have turned extremelycautious on the stock, but do not want to miss out if the stock were torise significantly? In either case, you may be willing to take aìdeductibleî on your time premium insurance.
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For instance, ifyou are bullish and are willing to forgo some of your insurance on thedownside (against cash losses), then you can take the ìdeductibleî bybuying the out-of-the-money $40 strike put for $0.75.
The $5.00difference between the stock and the strike price represents yourdeductible. That is how much you are willing to give up before yourinsurance kicks in. On the upside, your profits will be greater,because you have bought less insurance.
Alternatively, if youare very cautious about holding the stock, but donít want to fullydiscount the possibility of a large rise, you can take a deductible byhedging with the in-the-money put. By buying the in-the-money $50 putfor $5.65, you have effectively taken a $5.00 deductible on possiblegains.
Remember that your time premium is only $0.65. At expiration,for all outcomes below $50, gains and losses in the stock and theoption offset each other, so that all you will lose is the $0.65 timepremium. If the stock goes from $45 to $60, you will have made $9.35,($15 less your $5.65 premium).
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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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