Time, Price, and an Option’s Profitability

12/23/2009 12:01 am EST

Focus: OPTIONS

One of the most frequently asked questions I hear is: "The stock is trading above the strike price of a call option I've bought; so why isn't my option profitable?"

In most cases, if a stock is trading at $55 and you are long call options at the $50 strike, your option will be in the money, and thus, valuable whether you want to sell it at market or exercise your right to purchase shares at $50.

Under ideal circumstances, if the stock price has exceeded the option's exercise price, you've become the proud holder of an in-the-money call option that can be exercised for stock or closed directly for a profit.

Dial “V” for Volatility

There are a number of factors that influence an option's price. Volatility is oftentimes a culprit because the more volatility exists in the broader market (or in a particular sector or in a company's shares) at a given time, the steeper the option premium you might pay to initiate a trade.

Timing (i.e., when you initiate a trade) of your purchase goes beyond volatility. For example, if you buy a call with a $50 exercise price when the stock is trading at $45, the option should be significantly cheaper than if you buy it when the stock is trading at $52.

Buying an out-of-the-money option in this case (for example, buying the call option with the $50 strike price, with shares trading at $45) means that you're projecting the stock will make a dramatic spike during the life of your contract.

Relatively speaking, though, a $5 jump in an actively traded stock might not be considered a dramatic move. But if you're looking for the stock to move that much in a month with no potentially positive catalysts on the horizon such as an earnings announcement, what started out as an inexpensive bet might turn into a big loss.

When It’s Time to Buy, Buy Time

The closer that option is to its expiration date, the less value it has, especially if its prospects of finishing profitably are looking slim. That's because part of an option's worth is known as time value (that is, the more time you can give the stock to move, the more valuable the option therefore is).

So, it might be possible for that $45 stock to go up five or more points, but if you expect it to happen in a couple of weeks, you may lose out on this potential upside. However, if you foresee a stock making a five-point move in the space of six months, you may want to buy a call option that expires nine months from now.

You can always exercise or close your position at any time during the life of the options contract. And frankly, it's often wise to take advantage of time value and take profits on your trade sooner rather than later, especially if the underlying stock has hit its target trading price.

Yes, it's possible that the stock might keep going up. But there's also a chance that it will reverse course and go down before the option expires or the position is closed.

However, if you buy a call option with a $50 strike price while the stock is trading at $52, the option is already in the money. And buying in-the-money calls is fine as long as you have time on your side.

At Expiration Time, What Makes You a Winner?

If you buy the call two weeks before it expires, you're probably not going to make too much of a profit. But if you buy options with significant time left before expiration, you are giving the stock three extra months to make an even bigger upward move, which would typically make your option profitable.

So, if you buy an in-the-money call and the stock doesn't have time to make much of a move, your option may be profitable. But depending on how much you paid versus how much upside you were able to capture, you might not be banking an impressive return.

Similarly, if you are holding an option at the $50 call strike and the underlying stock finishes at $49.99, unfortunately, it's close, but no cigar! Even if the stock manages to finish at $50 or a few cents above it, the option may still expire worthless.

Paying a Few Cents More May Up Your Odds of Profiting Big

You can buy options up to two-and-a-half years before they expire. These are called LEAPS, and they cost a bit more than shorter-term options. (Shorter-term options typically expire in nine months or less). But if you're looking to profit from a significant stock move, the extra expense for the added probability of profiting may be worth it.

As you can see, the stock price greatly affects the price of the option, but it's just one of many factors that can impact your trade.

The moral to the story is to get into trades where you can not only recoup your commission costs, but also walk away with a profit on top of that. The less you pay and the more the stock moves, the more money you can make. And that's why we're all in this game!

By Dawn Pennington, contributing editor, OptionsZone.com

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