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Tuesday, November 11, 2008 3:36:50 PM
Option prices (puts and calls) are made up of three components. An intrinsic value, a volatility value and a time value. The intrinsic value is the difference between the stock price and the option strike price. If the option is out of the money, then the intrinsic value is zero. The farther out of the money it is, the more it will reduce any volatility or time value. The option price is increased by the expected volatility of the stock. Options on stocks that have wild swings have a high premium, while options on stable stocks have lower premiums. The time value is higher the more time is left, as obviously the more time there is, the more likely it is that the price will move the desired direction during that time.
Yes, the December puts are pricey, but it's because there is a major unknown coming in two weeks that will likely cause a big price movement. The reason some folks may wait until November 24 to buy puts is that they may believe that there is little risk of significant bad news before November 25. The expectation is that the decision will be handed down on the 25th. Why would the judge issue the decision early? He wants a settlement and knows that settlements tend to happen right before the decision, so I doubt he would possibly derail a settlement by announcing a decision early. If one believes that, then waiting makes very good sense. If there is a settlement before then there is no need to buy a put. It also will tend to reduce the time premium. However in IDCC's current situation, I don't think it will affect it much. The time premium is right now is greatly influenced by the ITC date because that is the date that something big is likely to happen. I was considering buying some December puts and selling November puts a couple of weeks ago, but the price discrepancy was very large. That makes sense because the big potential for bad news is November 25. If the ITC date was somehow moved to December 26, I believe the December puts and calls would fall significantly.
Someone asked why would you buy puts if you believe that long term IDCC will get paid and the price will be much higher. Well, if you bought some puts and the price does fall, you can sell the puts for a profit and take the proceeds and buy more stock at a cheap price. That way you protect the downside without forfeiting upside potential. Selling the stock and sitting on the sidelines for the decision gives you much better protection (you are selling at $22, not $18 ($20 strike price less $2 premium), but you will miss out on the jump in price on the news. Don't forget to consider the tax ramifications of the trades as well. Long term buy and holders don't have that problem. Everyone has to decide what is best for their situation.
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