Chris Rowe

   

RULE NO. 3: BUY PUTS THAT ARE DEEP IN-THE MONEY

What do I mean by that?

Let's say that a stock that you think is going to trade lower is at $40 per share. You may have several puts to choose from.

For example, study the option chain below:

The XYZ April 45 Put is in-the-money by five points, because the stock is trading at $40. In other words, if I owned a put option contract that gave me the right to sell XYZ stock at $45, and at the same time the stock had a current market value of $40 per share (where I could purchase it), I could make a five-point profit on the difference between the sell and the buy if I were to execute both trades simultaneously.

Notice that the April 45 Put above is trading at $5.65. The option -- which, as I mentioned, is five points in-the-money -- is worth at least $5 since one can profit $5 per share from the difference between where we can sell the stock and where we can buy the stock the same day.

So why is it at $5.65 and not just $5?

In that $5.65 put option, the $5 by which the option is in-the-money is called the "intrinsic value." The remaining 65 cents is called "time value" (or "extrinsic value").

The reason that the option is trading at $5.65 (i.e., 65 cents higher than $5) is because the put option is considered to have additional value since it won't expire for several months.

If your stock trades in the wrong direction (i.e., up, if you've bought a put option), having several months until the option expires gives you the luxury of having time on your side to wait it out, and see if the stock does what you want it to. The longer your option has to expire, the more time value may be included in the price of the option.

For example an XYZ year 2010 Jan 45 Put (which expires eight months later than the example above) might be trading at $6.65 ($1 more than the example above), which would mean that it has $1.65 in time value and still has $5 intrinsic value, as it is still five points in-the-money.

As illustrated in the option chain above, an option contract that is deeper in-the-money will have less time value than one that is less in-the-money. The price of an option that is not in-the-money at all will only consist of time value, which means that if the stock trades flat, your option would trade to zero.

Hence, this is the reason that we look for options that are in-the-money.

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