HAD WE BUT WORLD ENOUGH, AND TIME. PART DUE

HAD WE BUT WORLD ENOUGH, AND TIME. PART DUE. (i )

In the last post we defined the Intrinsic Value and the Time Value of options. Specifically, we looked at April 2006 Calls for MonopolySoft (MPST), a computer software company. We think that MPST will rise from $25 to $30 per share in late January or early February of 2006 and the value of the Call will also rise.

Below are the Calls we considered:


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.

We specifically analyzed the Call with a Strike Price of $23 that is $2 in the money. The premium for this call is $3. Recall that the Intrinsic Value of this Call is $2. ($25 Stock Price - $23 Strike Price = $2.) The Time Value of this Call is $1. ($3 Premium - $2 Intrinsic Value = $1.) This Call represented the best value so we bought a contact at $300. ($3 Call premium * 100 shares per contract).

Calls 2 and 3 have no intrinsic value and consist entirely of time value. Call 2 is at the money. The Strike Price equals the stock price so there is no intrinsic value. The entire $1.00 premium is time value.

Call 3 is out of the money by $2. ($25 Stock Price - $27 Strike Price = ($20).) The entire $.33 premium is time value. Its low value of $.33 reflects that fact that is $2 out of the money.

TIME VALUE IS THE PLAY CLOCK FOR THE INTRINSIC VALUE GAME.

Many things can happen to MPST stock between now and April 16, 2006. Let’s look at some hypothetical activity between now and expiration of our Call.

December 20th - MPST CEO Steve Balderdash announces that the next release of the MonopolySoft Operating System will not allow the Gobble, Inc. search engine to run on the MonopolySoft system. MPST stock rises to $28 per share on this news. Our Call, that has a Strike Price of $23 and a value of $3, rises to $6 (ii). In this case, the intrinsic value of the Call rises to $5. ($28 stock price - $23 strike price = $5.) Further, there is no longer any time value to be allocated to the Call since the intrinsic value of the Call exceeds the premium cost we paid for the Call. ($3 premium -$6 intrinsic value = ($3). Not a bad Christmas Present.

January 15th - Gobble, Inc., the search engine giant, sues MonopolySoft for violations of anti-trust law. MPST stock falls to $20 per share. The Call has lost all of its intrinsic value and is now comprised solely of time value. ($20 Stock Price - $23 Strike Price = ($3) Intrinsic Value.) Since we have no intrinsic value, our Call is now worth $3 of time value. ($3 premium -$0 intrinsic value = $3 time value.) And the value of out Call would also fall in value, since it is now $3 out of the money. But we still have three months to go until expiration, so there can still be good news that will raise the price of MPST.

February 15th. MonopolySoft announces that it will delay release of its 2005 earnings due to “accounting irregularities”. The stock falls to $15 per share and our Call is now $8 out of the money. ($15 Stock Price - $23 Strike Price.) It has no intrinsic value. And we might be starting to worry. We only have two months left and our Call is nearly worthless, as it has fallen to $.15.

But at my back I always hear, Time's winged chariot hurrying near(iii).

With only two months left in the life of the Call, and the Call now $8 out of the money, most would close out the Call and cut their losses. But we have faith in the power of anti-competitive conduct to rally MonopolySoft stock. On April 1st, MonopolySoft releases its earnings and 2005 shows a 40% increase over 2004. Also, on this auspicious day, the Supreme Court dismisses Gobble, Inc.’s lawsuit against MonopolySoft. MPST stock soars to $50 per share. Our Call rises to $25 and we close it with a sale for a $2,200 short-term capital gain. ($25 Call premium value - $3 Call Premium Cost = $23 per share * 100 share per Option Contract).

Saved, just in time. Steve Balderdash can buy another professional sports league and we have pocketed a nice gain. And Internet progress is set back six years. Two out of three ain’t bad.


Thus, though we cannot make our sun stand still, yet we will make him run(iv) in The Desert of the Real!

i. Marvell, Andrew. “To his Coy Mistress”.
ii. This means our Call has a delta of 1. For each dollar in value that the stock rises, the value of the Call rises by $1. See the Author’s post “Options in Operation”, dated November 2nd, where Delta was explained.
iii. Marvell, Andrew.
iv. Marvell, Andrew.