Options Forum: Never Rich Enough

Steve, thanks for all the good stuff. I was wondering if you had any thoughts on a recent options trade. I had bought KLA-Tencor(KLAC Quote) 12/60 puts before the close on Tuesday for $3.50 with the stock just over $60. I just sold them for $7.50 with the stock around $53.30. So I got a whole 80 cents of time premium with nine weeks until they expire. That's nuts! There should have been at least $1.50 to $2 of time premium built in. There is not an ounce of fear in this market, and I find that quite frightening.

--M.B.

Don't be frightened -- be glad. It sounds like you made a great call and realized a 114% gain on your option trade. Still, there are two elements worth addressing here -- accurate projections for a potential profit and loss, and what an options pricing might be saying about investor sentiment.

Great Expectations

Thinking you've made the "right" call and that you aren't being duly rewarded is one of the great frustrations of trading options. When an options position changes in value and it doesn't correlate with your expectations for the given price change in the underlying security, you must first ask yourself if you had realistic expectations.

In the reader's example, the resulting 100% increase in the price of the put for the approximately 11.5% decline in KLA-Tencor is about what should have been expected. The first step in gauging how an option's value will change relative to a move in the underlying stock price is understanding the delta. (Please look at this past column for a more in-depth discussion on delta.)

The reader purchased an at-the-money put with nine weeks remaining until expiration, which according to my handy options calculator means it had a delta of negative 0.48 when purchased. This means that for every dollar decline in KLAC's share price, you'd expect the December 60 put to increase 48 cents. So the fact that a $6.70 decline in KLAC's stock price resulted in a $4 increase in the put's price seems about right. Remember: Delta isn't linear, its rate of change (defined as gamma) increases and decreases on a sloped scale. With KLAC at $53.30 the put's delta is now negative 0.77.

The lack of perceived premium has more to do with the fact that the puts have moved into the money than to any change in volatility or time remaining. As options move further into the money, their price increasingly comprised of intrinsic value. On the other hand, out-of-money options have no intrinsic value so their price is comprised entirely of time premium and implied volatility.