You could buy a July option, which has a 26% volatility level at the money, for about $1.23.
Let’s analyze this for a second. I want to show you that volatility does actually increase the price of options.
Here we have the July 47 put. If we were to purchase this as protection, and the volatility level is at 26%, let’s see what happens when we adjust the volatility, and volatility goes higher. You can see that as volatility increases, the profit and loss will increase dramatically as well.
If we adjust the volatility back to a 0 point, so volatility is currently at 26.03% for that particular option, we can see that we have a loss of $1.22 on that option. If volatility were to increase by one percentage point, now we have a profit of $4.32, on that one option.
The volatility will increase the profit potential of that particular option. However, if you buy an option with an extremely high volatility level on initiating, and the volatility were to come down, you would lose money on that option.
It’s important to understand that when you’re purchasing options for particular stocks as protection on a put position, you want to try to purchase your put options, your insurance, at a lower volatility level. You don’t want to purchase them at the 50% level. Depending on the stock, that could be high or low. Generally, the 50% level is pretty high.
Let’s take a look at the volatility for Starbucks. Generally, the market has come down. If the stock has come down dramatically, the volatility of those particular options will also increase in price. The volatility will also increase.
Let’s take a look at Apple. Let’s see what the volatility of Apple is. Even Apple is at 48%. If we take a look at Apple, unless it’s come down recently – it has. It’s come down a little bit here. In fact, it’s come down quite a bit today. Maybe that’s why there’s an increase in volatility levels.
The volatility levels would have been a little lower up here. Now, they’re at 48%, which is pretty high. Apple is down over $6 today. Volatility levels do have a dramatic influence on the price of particular option prices and stocks. You generally want to buy put protection, based on a lower volatility.
The only way that you can do that is by purchasing stocks that have already been increasing in price. Generally, if it’s increasing, price is a good reason for that. You generally want to buy stocks that look like they’re going up anyway.
There’s one last component to this type of a system that I wanted to talk to you about. The profits can really be dramatic. Let’s take Apple for a second. If you were to purchase Apple up here, at $200 a share, I think you would be really disappointed to see the stock drop dramatically here, down into the $120s level. That’s an $80 a share decrease in the price.
If you didn’t purchase your put protection up here, you would have gotten decimated in this stock. Just think about it for a second. 1000 shares of Apple, at $200 a share, is a $200,000 investment. If you had no protection on that, that’s the price of a house, in some small communities.
You would be very foolish not to have some sort of insurance protection. That’s what put options really are, when you combine them with the purchase of stock. It’s insurance.
If you purchased a put option here, on 1000 shares of Apple stock, instead of losing $80,000 on your investment, you would have made close to $79,000 in your put options, without any additional money. You could have used that $79,000, then.
Let’s say you purchased an at the money put option as insurance and protection for the $200,000 price of the purchase you just made, of the 1000 shares of Apple, at $200 a share. It dropped, and went down to this $120 level, when you decided to cash in the insurance.
You would have made close to $80 on the put option that you purchased. At 10 times 80, that’s $80,000. Let’s say you had a maximum loss of $1000, because this is pretty expensive stock. You would have cashed in that put insurance premium for $79,000.
How many shares of stock could you have purchased additional at this $120 – let’s say the $125 level. Let’s take $79,000, and divide it by 125. You would have purchased an additional 632 shares. Now, instead of having 1000 shares at this 125 level, you would have had 1,632 shares.
You lost $1000, because you were smart enough to buy insurance, when the stock declined.