Put Time and Volatility on Your Side

The market is a crazy and dangerous place. As a result, stock prices can swing wildly one way or the other, and retail investors like you and me can feel like we're along for the ride and that big money traders control our financial destiny.

But there are tools available for minimizing some of the risk in our portfolios. Stock options can play an important role in buying and selling stocks. You don't have to be a professional options trader. Just know a few of the basic rules of the game to make it work for you.

Knowing the basics
There are two kinds of basic options investors can use: calls and puts. Calls give the owner the option to buy a stock at a set price on a set date. Puts give the owner the option to sell at a set price on a set date. They also represent a "bet" on what direction the stock is headed. A call owner wants the stock to go up, and vice versa.

Option Type

Buyer

Seller

Calls Long stock Short stock
Puts Short stock Long stock

So let's take a look at LED light maker Cree (Nasdaq: CREE  ) . If I think the recent drubbing the company took is a little overdone and I want to be long the stock, I have three choices:

  • I could buy shares, earning profits if shares go up but losing money if they go down.
  • I could buy a call option, paying a fixed amount upfront to give me the right to buy shares later at a given price. That way, I can only lose what I paid for the option, but I still have unlimited upside.
  • I could sell a put option, committing myself to pay a fixed price for shares even if the stock falls below that value. In the meantime, I'd pocket the money I received when I sold the option.

The price of put and call options depends on the price of the underlying stock as well as two other important factors.

Putting time on your side
Part of the value of an option comes from how long you have until the option expires. In general, the longer an option has until expiration, the more valuable it is.

If you want to make a bet that biotechnology firm Dendreon (Nasdaq: DNDN  ) is going up after big name investors Ken Griffin, Stephen Cohen, George Soros, and David Shaw took large positions in the company, you may want to buy calls. Conversely, if you're sitting on big gains after ATP Oil & Gas' (Nasdaq: ATPG  ) long run higher following the reopening of the Gulf to drilling and want to lock in some profit, writing calls can earn you a quick option premium payment. The length of the option you chose affects the price you either pay or receive for the option as you can see below.

Company

Option Strike Price

April Call Price

May Call Price

Dendreon $38 1.27 2.61
ATP Oil & Gas $18 0.43 1.24

Source: Yahoo! Finance.

As you can see above, the May options for these companies are more expensive than the same April option. This is simply because the May option has more time left on it and more time for the option price to decay.

Don't be afraid of volatility
Volatility is another main component in pricing an option and can be a great tool for those of us who invest in volatile markets. Two sectors I follow closely -- solar and gaming -- are extremely volatile, and options can come in very handy.

How do you spot a volatile stock? Just check out a stock's beta to get a good idea. Two stocks with a similar stock price but vastly different betas will have great differences in option prices. For example, according to Yahoo! Finance, Las Vegas Sands (NYSE: LVS  ) has a beta of 4.07, while a similarly priced stock, Disney (NYSE: DIS  ) , has a beta of 1.19. The vast difference in option prices shows how this affects option values.

Company

Recent Stock Price

Option Strike Price

May Call Price

May Put Price

Las Vegas Sands 44.70 $45 2.80 3.05
Disney 42.55 $43 1.20 1.52

Volatility can come from a lot of places, but in the case of Las Vegas Sands, it comes from a highly leveraged business -- and the risk a casino operator takes as a result. Disney, on the other hand, owns a much more steady business with theme parks, movies, and television networks. As a result, Disney's options don't cost as much as options on Las Vegas Sands. It doesn't make one or the other a better investment -- it just affects the price of their options.

Those are some of the basics of how time and volatility work for option prices. Stay tuned tomorrow as I continue my look at options with a strategy that lets you buy stocks at a discount or sell them at a premium.

Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

Walt Disney is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 05, 2011, at 3:12 PM, millsbob wrote:

    "...retail investors like you and *me*", not "I".

    and more substantively: why doesn't anyone at the Fool, including you, Travis, ever write anything positive about GT Solar? in particular, regarding options? you cover much riskier solar plays extensively, but i've made a small fortune over the past year with SOLR options. and it's the only solar play that's also on Joel's Magic Formula list.

    it really does seem like you're embargoing this one stock... i can only remember one Extremely brief article on them in the past 2 years, and even in articles on the solar industry, you sometimes omit them entirely, or just make passing mention.

    imo, they are a more reliable way to be in solar. am i missing something that makes TMF recommend other companies that seem inferior from just about every perspective i can find?

  • Report this Comment On April 05, 2011, at 11:09 PM, TMFFlushDraw wrote:

    http://www.fool.com/investing/general/2011/01/20/clean-tech-...

    http://www.fool.com/investing/general/2011/02/03/gt-solar-is...

    There are two articles I've done this year that talk about GT Solar pretty extensively. You're right I could probably do more writing about them. I'll take that under advisement.

    Travis Hoium

  • Report this Comment On April 06, 2011, at 10:50 AM, millsbob wrote:

    thanks, Travis. while i wouldn't call the brief paragraph in the January article "extensive", i hadn't seen the Feb 3rd article, which does have background information of which i was not aware.

    so, thank you for that, and i hope you do find time to keep us up on SOLR and other companies in the industry in addition to the ones that are currently high profile for the Fool. because i value your coverage -- and that of Anders Bylund and Erik Bleeker -- at least as much as the subscriptions i've had to various TMF services.

  • Report this Comment On April 06, 2011, at 11:31 AM, svaiskau wrote:

    I don't think selling a call option necessarily puts you short on the stock, it just curbs your long interest. For example, if ABC is trading at 10 and I write a Jan 12 call for 20, my best outcome is that the stock rises to $19.99 and the option expires out of the money. That way I keep my position, which has increased in value, while also collecting the premium on the option I wrote. I think this is what confuses the average investor and makes option confusing... There are unlimited upside short and unlimited upside long options, but there are also varying degrees of each, which are inverted depending on whether you are buying or selling. In this way, I liken writing call options as a chance at being the casino for value investors... You can collect small premiums at very low risk (the house's edge) while maintaining the long position that got you into the stock in the first place. Even when the house loses, you've still made some money, as long as your calls aren't in the money at the time you write them.

  • Report this Comment On April 06, 2011, at 8:02 PM, millsbob wrote:

    if ABC is at 10 and you write a Jan12 call for 20, you won't even get enough for the call to cover the commission.

    covered calls are the easiest options to get permission to write, but in my experience, only useful for stocks you want to get rid of.

    obviously, if you buy stodgier companies, covered calls can be useful. i suppose once i'm 90, that strategy may appeal. for now, it's only cost me big time when the underlying zoomed, because -gasp- i don't tend to buy stocks i expect to stagnate.

  • Report this Comment On April 14, 2011, at 6:12 PM, TMFFlushDraw wrote:

    @svaiskau

    Selling a call is a synthetic short. Think about it if the call was by itself and not covered. If you sold a call in ABC and had no other position you would want the stock to go down.

    That's why you're "short the stock".

    Travis Hoium

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