Thursday, August 3, 2017

AUGUST 2017 DESERT OF THE REAL ECONOMICS NEWLSETTER



HAD WE BUT WORLD ENOUGH, AND TIME 

HAD WE BUT WORLD ENOUGH, AND TIME. ([i])

It is beyond cliché to say, “Time is Money”. But it usually is and that is why the oft-cited aphorism survives. This Newsletter will look at some options basics, as that is all the Authors are trading. This post will look at the “time value” component of options and how the limited life of an option affects the value of an option. But first let’s talk a bit about where we are at in the markets.

The Dow has broken 22,000 and the S&P and NSDQ are also at record levels.  And The S&P 500 hasn't suffered a downturn of 5% or more since June 26, 2016. And the VIX, a key volatility index, is coming in at record lows. So effectively this market is driven to higher and higher returns on low volume.  Everyone assumes a pull back is coming. But when? August, September, and October are typically weaker months for the market.

THE EXPIRATION CYCLE OF OPTIONS

As we know, options are contracts to buy or sell a specific security at a specific price on or before a specific date. The expiration cycles of options are standardized. The three cycles are:

1. January, April, July and October. (JAJO).
2. February, May, August and November. (FMAN).
3. March, June, September and December. (MJSD).

Options expire on the third Saturday of the month. The last time to execute an option is at close of the Options exchange on the Friday before. After the option expires, the option is worthless. So in addition to considering the type and strike price of the option, we must also consider the time until the option expires.

TIME VALUE AND INTRINSIC VALUE

Options have two types of values: Time Value and Intrinsic Value. We will do a little review on the concept of “in the money”, “at the money” and “out of the money”, and then montage into the concept of time value.

Options can be “in the money”, “at the money”, or “out of the money”. To illustrate, we will use Call examples for the bloatware company MonopolySoft (MPST). MPST is currently trading for $25 per share. We are interested in the April 16 Calls.

We believe that MonopolySoft will rise in price when its 2015 earnings report is issued in late January or early February. We believe that it will rise to $30. So we go to the MonopolySoft options montage in our online brokerage site. There are three April 16 Calls we are considering:

1. Call with a Strike Price of $23. The premium for this Call is $3. This call is in the money by $2. ($25 (stock price) -$23 (strike price)= $2.)
2. Call with a Strike Price of $25. The premium for this Call is $1.00. This Call is at the money because the stock price equals the strike price.
3. Call with Strike Price of $27. The premium for this Call is $.33. This call is out of the money because the strike price is higher than the stock price.

TIME VALUE AND INTRINSIC VALUE CALCULATION

Intrinsic value is the amount that the option is in the money. If it is a Call, it is the amount by which the stock price exceeds the strike price. If it is a Put, it is the amount by which the strike price exceeds the stock price. Stated another way, the intrinsic value is the amount we could make on the option if we exercised it. If we exercised the Call with the $23 Strike Price we could buy MPST at $23, sell it at the market price of $25, and make $2. This $2 profit is drawn from the option’s intrinsic value.

We could do that and earn the intrinsic value of the Call of $2. But if we did exercise we would still lose $1. Remember, we paid a premium of $3. So if we sell it for $2, we would lose a dollar. It is this $1 difference between the intrinsic value and the premium we paid that is the time value of the Call.

TIME (AT LEAST FOR NOW) IS ON OUR SIDE

The April 16 MPST Calls will expire on April 15th (Hmm, what a coincidence). They must be exercised no later that Friday, April 14th. So if we buy an April 16 Call it has almost 5 months until expiration. A lot can happen in that those five months, and that is to our advantage. There is an aphorism in Options trading that says: “Give yourself enough time to be right”. Many things can go right in the five-month life-span of the April 16 Call to cause MPST stock to go up in price. And if MPST goes up in price, our Call will go up in value. And even if MPST slips in price tomorrow, we still have nearly five months for the stock to turn around.

So with nearly five months to go in the April 16 Call, time is on our side. Let’s put a number to the time value of this April 16 MPST $23 Call:

$25 Stock Price - $23 Strike Price = $2 Intrinsic Value.

But since the Premium cost us $3 and the Intrinsic Value is $2, the Call has a Time Value of $1:

$3 Call Premium - $2 Intrinsic Value = $1 Time Value. So the Time Value is the cost, or value of the premium that exceeds its Intrinsic Value.

But what would happen if we have a Call that has no intrinsic value? Like a call that is at the money or out of the money? The entire value of these calls is composed of time value. We will look at this issue and the affect of option values as they approach expiration in another post or newsletter.

And yonder all before us lie[ii] The Desert of the Real.

For fun and for your literary enrichment.

To His Coy Mistress

by
Andrew Marvell

Had we but world enough, and time,
This coyness, Lady, were no crime.
We would sit down and think which way
To walk and pass our long love's day.
Thou by the Indian Ganges' side
Shouldst rubies find: I by the tide
Of Humber would complain. I would
Love you ten years before the Flood,
And you should, if you please, refuse
Till the conversion of the Jews.
My vegetable love should grow
Vaster than empires, and more slow;
An hundred years should go to praise
Thine eyes and on thy forehead gaze;
Two hundred to adore each breast;
But thirty thousand to the rest;
An age at least to every part,
And the last age should show your heart;
For, Lady, you deserve this state,
Nor would I love at lower rate.
But at my back I always hear
Time's wingèd chariot hurrying near;
And yonder all before us lie
Deserts of vast eternity.
Thy beauty shall no more be found,
Nor, in thy marble vault, shall sound
My echoing song: then worms shall try
That long preserved virginity,
And your quaint honour turn to dust,
And into ashes all my lust:
The grave's a fine and private place,
But none, I think, do there embrace.

Now therefore, while the youthful hue
Sits on thy skin like morning dew,
And while thy willing soul transpires
At every pore with instant fires,
Now let us sport us while we may,
And now, like amorous birds of prey,
Rather at once our time devour
Than languish in his slow-chapt power.
Let us roll all our strength and all
Our sweetness up into one ball,
And tear our pleasures with rough strife
Thorough the iron gates of life:
Thus, though we cannot make our sun
Stand still, yet we will make him run.


[i] Marvell, Andrew, “To his Coy Mistress”. Some readers may have read this poem in high school or college literature classes. All though some of the phraseology is dated, the message is universal. And the Author Rob does not even wear a watch.
[ii] “To his Coy Mistress”.