Valuing Options

Here is a little overview on valuing options. It is taken verbatim from www.888options.com - with a little bit of commentary:

Basic Rule - The premium of an option has two main components: intrinsic value and time value.

In order to calculate the intrinsic value - you just subtract the strike price of the option you are considering from the current price of the stock.

In order to calculate the time value - you subtract the intrinsic value of the option as defined above from the market price of the option. It will quickly become obvious - that if you are dealing with an option with a strike price above the current market value - that its premium is composed entirely of time value. There is no intrinsic value because if you were to purchase the option and the prices did not change - it would expire worthless.

When I evaluate options I typically purchase only in-the-money options. I look for opportunities to leverage myself at a high ratio but where there is a very small time value component in my options' prices and I am instead purchasing an option with a premium that is based on almost 100% intrinsic value.

We can also do a quick example with some options that I am currently considering purchasing (not for a few more weeks - but these are what I am looking at):

Symbol (.NEMAH) - this is another derivative of Newmont Mines (NEM). This time the January 2006 call option with $40.00 strike price. At the current market price of $4.50 for the option and a market price of $42.44 for the common stock we can quickly apply our formulas.

The intrinsic value of the option is only $2.44 ( market price of stock (42.44) - strike price of option (40)). Then we can calculate the time value of the option by subtracting the instrinsic value (2.44) from the market price (4.50) - to yield a time value of $2.06.

Another useful tool that I like to use is to consider the % cost that I am paying in order to gain the leverage. Here I would gain leverage of approximately 10-1. But my carrying costs are considerable. If I divide the time value of the option by the market price of the stock - I can see that I am paying an additional premium of almost 5% of the stock price in order to generate that leverage. My favorite opportunities are where I can generate 15-1 or even 20-1 leverage at a cost of less than 2%. Obviously these opportunities are not as common.

Given that I am very bullish for Gold's prospects over coming 6 months, I may choose to purchase these options even though I think they have a relatively high cost. I do expect a substantial correction in Gold and Gold Miner's Shares following the 9/20 Federal Reserve meeting where I expect them to announce continuing rate hikes based on inflationary pressures. Obviously this is a bunch of hocus-pocus - nobody knows what is coming for sure other than Alan Greenspan. Still - there have been a ton of calls on both sides of this from very smart people - so we can expect a lot of volatility after the meeting as things become clearer and everyone gets repositioned. As I mentioned earlier - I am going to be in 100% cash until the news has been announced barring a total change of heart.

If my scenario unfolds as expected - I should be able to pick up my NEM options at a much lower cost as the common retests the $40 area and the options go down to $2-$3 each. Given that I expect NEM to be trading north of $50 a share by January 2006 - it could be a great play. The leverage that I am hoping to generate as well may enable to me to commit a relatively small portion of my capital (re: less than 20%) to the gold positions and still produce outsize gains if I correctly anticipate the future course of events.

That is it for this Sunday. We will see how I fare in my final week of the NEM speculation. I am so far really enjoying this blogging journey.

Best Regards,

BG