There’s a better way to profit from options
So this is weird.
On 11 April someone detonated three bombs near to Borussia Dortmund’s team bus.
No one was killed, but one player had to have wrist surgery and a policeman was treating for shock, according to press reports.
Now here’s the weird bit.
The guy they’ve charged with the attack apparently did it as part of an options trade.
As the BBC reports:
“The suspect had allegedly bought 15,000 put options on Borussia Dortmund shares – reportedly priced at €78,000 (£65,000; $83,600) – betting that they [i.e. the shares] would drop sharply after the attack. He would have profited from this fall.”
The idea behind this scumbag’s attempted trade was straightforward, even if his methods were highly unorthodox and illegal.
A put option gives the holder the right to sell the underlying shares at a guaranteed price (the strike price).
So, if you hold a put, you stand to make a profit if the shares fall.
There are two ways to think about why that is.
The first is the one you usually come across in text book explanations.
If your put option means you can sell the shares for, say, €5.50 (the strike price of your put) and they fall to €5.00, you can buy the shares at the lower market price and sell them for the higher strike price.
Voilà! You’ve made a profit.
In practice, though, that’s not how you’d actually go about cashing in.
A little terminology will help us see why.
When the current market price is below a put option’s strike price, the put is said to be “in the money”.
(Similarly, a call option – one that gives you the right to buy share at a given strike price – is in the money if the current market price is above its strike).
For an in the money option, the difference between the strike price and the current price is known as the option’s intrinsic value.
But the value of an option – known as the premium – isn’t just determined by its intrinsic value.
There’s also what’s called extrinsic value. And one of the things captured by extrinsic value is the volatility of the underlying asset.
Rule-of-thumb – the more volatile a share price is, the more extrinsic value its related options will have.
In other words, a spike in volatility tends to boost option premiums.
So say you’re a criminal looking to commit some nefarious act to send the shares of a particular company lower.
If you’re successful, then your puts should be boosted not just because the share price is lower but also by the spike in volatility.
Both would serve to boost the option’s premium. And so the way you’d actually cash in would be by selling your put back to the market at a now inflated value.
I feel a strong urge at this point to make clear that this is in no way an endorsement of buying puts on football club shares then trying to blow up the team bus.
For one thing, Borussia Dortmund’s shares are currently only around 1.5% below where they were at the time of the attack.
And that’s mainly because they’ve been knocked out of the Champions League by Monaco (the team they were meant to be playing that night)
The shares did open lower the morning after the bombs went off – but only around 1.5% lower (so they were trading then around where they are now).
So it would have been a small window in which to make a rather small profit.
Oh, and – to state the obvious – blowing up buses is illegal and not very nice. And you go to jail for it.
Besides, I’m about to show you a much, much better way to make money from options.
It has the following advantages:
- You can do it over and over and over again…
- You can use this with multiple companies and make your trade at a time of your choosing…
- You don’t need to blow anything up – in fact, you can do this with no explosives knowledge whatsoever.
And it can be especially lucrative in choppier markets…
Remember I talked about how a spike in volatility tends to boost an option’s premium.
I used the word ‘spike’ because, very often, heightened volatility may persist for a bit but will then die down to a more typical level fairly quickly.
The spike in volatility creates a window in which to make extra profits. But there’s a trick you need to use…