Don’t time trades… Trade TIME!

In this article we’ll explore one of the great keys to trading RadioActively: the phenomenon of options premiums swelling ATM (at-the-money).

This phenomenon, and particularly what you can DO with it, is consistently overlooked by folks that still believe in timing trades and using stop orders to time their trade exits.

Today I’ll show you a true story of how the time value in a put option I was holding MORE THAN DOUBLED… as the stock went up. Then I used the time value of the put to “bulletproof” a stock before the earnings announcement that sent it even higher… without selling calls.

Here’s an objection that keeps coming up, concerning the purchase of in-the-money put options. Often when I put together an RPM (RadioActive Profit Machine, my trademark term for a married put position with the put being five or more months out, and in the money), there’s a lot of attention given to how expensive the put option is. After all, I may spend 20% or 25% of the position’s total value on the put.

Let’s take a look at what I’m talking about here. Consider the setup of the RIMM RPM:

See that? The put option costs $24.70, a pretty significant part of the total position’s price of $108.74.

Now, many folks would say that choosing this particular strike price for the put is EXPENSIVE… but I want to point something out. The put is deep in-the-money, meaning that it’s mostly intrinsic value. The intrinsic value is added to the stock’s current price to make $100 even, out of only $108.74 total invested. No matter what happens to the stock before expiration, MOST of the amount of money that I “put” into the put is guaranteed to come back.

So as a part of the overall position, it’s really not that expensive after all, is it?

Let’s consider what WOULD have happened of RIMM’s price dropped dramatically and I held on to the very end: because the put was so deep in the money, I wouldn’t lose the whole premium of $24.70… only the $8.74 that was AT RISK in the position to begin with.

This $8.74 is equal to the extrinsic, or time value, component of the option’s pricing. Again, that’s all we can lose here in case the position goes against us. But we’re not as excited about learning what happens when the stock goes down, are we? 😉 Let’s see what DID happen instead…

This RPM was entered on September 5, 2007. By September 27, 22 days after setup, RIMM rose above $100. Now, as a stock goes up, you’d expect the price of the put to go down, right? Of course. And, indeed, that’s what happened. On September 27, 2007, the put that I had purchased three weeks before for $24.70 was now worth only $19.80. That’s a price change (read: a LOSS) of $4.90.

That’s what a lot of folks focus on when trying to look for holes in my method: the loss of value in the put option as the stock price goes up. But let’s take a closer look, shall we?

In order for that in-the-money put option to lose $4.90, the stock had to go up by $16.00! Remember that I had purchased RIMM stock for about $84, and then it went up to over $100 over the next three weeks.

Hmmm… would it be okay with you if I took five dollars out of your left hand, while putting sixteen dollars into your right? Of course that would be okay.

See, when your put is in-the-money, the INTRINSIC portion of the price comes down dollar for dollar as the stock’s price goes up… so there’s no net loss. On the other hand, really interesting things happen to the EXTRINSIC, or time value portion of the price.

When I had purchased it on September 5, 2007 the put cost $24.70 but the time value portion was equal to only $8.74. As the stock went up, the intrinsic value came down an equal amount, until there was no intrinsic value left at all. Now let’s think about it a moment… now that RIMM is worth $100, the Jan 09 $100 put is ALL time value.

That means that the investment I made in time value ($8.74) had risen to $19.80… more than doubling! It’s this phenomenon that makes Income Methods #3 and #4 work; both IM#3 and IM#4 capitalize on swapping one put having a swollen time value component for a new put that has less time value.

Just before RIMM had its earnings announcement, I decided I wanted to know that I couldn’t possibly lose in case the news was bad… but not leave a lot of cash on the table in case the stock went up! I’ll give a hint or two right here about how I used IM#3 here, and you can tune in to the upcoming “Profits from Puts” online Seminar this July 18 for all the details.

Here’s what I was faced with: if I had sold an October $100 call option against this setup, it would have made this trade bulletproof all right. By selling a covered call against the stock in the RIMM RPM I would have collected $10.00 or so in premium, more than canceling the $8.74 AT RISK amount. Trouble is, if the stock went up explosively, that would seriously limit my potential gain while leaving me with a put option that was dwindling in value.

Income Method #3 to the rescue! By selling to close the Jan 2009 $100 put, and buying to open another put that had a lower premium, I was able to generate a $12.60 credit. At the same time, if the earnings announcement disappointed… I was still covered at a level of $100.

SO… Income Method #3 made me “Bulletproof”. from an initial AT RISK amount of $8.74 to a guaranteed return of ($12.60 credit – $8.74 AT RISK) = $3.86, I had no more uncertainty in this trade… except how much MORE I might be getting in case the news was good.

Well, it turned out to the good. After the earnings, RIMM skyrocketed nearly $20 per share. Remember, I still own the stock at this point… and with no call sold against it, I had no obligations at all to deliver at someone else’s price. Pretty cool, huh?

Choosing to add an in-the-money (ITM) put, as opposed to an out-of-the-money (OTM) put to stock that you own is like adding an insurance policy that has a higher level of coverage. Sure, you’ll pay more for the policy but you’ll enjoy a higher level of protection in case of an adverse move… well worth the extra cost. And..! In cases like the above, your put option can prove to be an additional source of income as well.

The ITM put is an integral part of every RPM (RadioActive Profit Machine) setup because it’s possible that the time value component will actually GROW, even after time has passed and after the stock’s price has gone up. This is certainly counter-intuitive, isn’t it… you’d think that as time goes by and as a stock’s price goes up, the put option can only come down in value. Happy thing is… that’s not how it REALLY works.

Come to the “Profits with Puts” Seminar on July 18… or get the recording… to learn all the details of how to use this unique property of options pricing to your advantage. As I like to say, “Don’t time trades… trade TIME!”