How does one make money, if I buy a call (in-money) and also buy a Put, at the same time?

Sensei answered 5 months ago …

To understand this, you must first understand two things:

1. What you're paying for when you buy and option.
2. What you're actually doing when you employ this strategy.

What you're paying for

When you buy an option, you're paying for two things:

1. Intrinsic value
2. Extrinsic value

Intrinsic value

This is the difference between the current market value and the strike price. Using your example, if I'm going to sell you a call (the right to buy the stock) at $45 when the market price is $60, you could immediately "call" my stock, pay me $45 and sell it for $60. While you'd make $15 on that, I'd lose that $15. Do you think I'm a total idiot? You KNOW I'm going to want you to pay me that $15 for the option to keep me "even" on the transaction. Right? So you're going to have to pay me at least $15 for the call. That's called "intrinsic value".

Extrinsic value

Again, using your example, you want me to give you that right to take my stock away for $45 at any time in the next year. Anything can happen in a year. You think the stock will go up. So do I - otherwise, I'd sell it now for $60. Right? Since we both think the stock will go up, I'm going to want something from you (i.e. money) for the privilege you will have to make me sell you the stock a year from now for $45 ... especially as it's now $60. That "extra" you'll have to pay me (the "time premium) is called "extrinsic value".

Say I want $5 of "time premium". Why? Because you have a year to act and, as I said, anything can happen in a year. The stock might be $80 by then. But say the option expires next week. What are the chances that the $60 stock will be worth $80 next week. Pretty slim. Right? So you wouldn't want to pay a lot for the time element. Maybe you'd be willing to pay 50 cents. From this, you know understand that the extrinsic value erodes over time.

Now, suppose the option expires in ten years. (Yes, you can't get an option for that long, but let's say you could.) You might be willing to pay $100 for that time. What if it expired in nine years? It's still a long way away, so you might be willing to pay $99. In the above example, the change in time of about a year (from next year to next week) reduced the extrinsic value from $5 to 50 cents - a difference of $4.50. In this case, the same time difference only changed the extrinsic value by $1. And now you see that extrinsic value does not erode arithmetically. In fact, it erodes parabolically. At expiration, the extrinsic value is zero.

These concepts are fundamental principles. If you don't understand them, read this again.

The Strategy

When you do this, you're effectively betting that at expiration the stock will either be lower than the call strike or higher than the put strike. If the stock is "in the middle" at expiration, what you make on the one, you'll lose on the other - plus, you'll lose the commission cost and the extrinsic value you've paid. (Note that there will be 4 commission costs - 2 on the entry and 2 on the exit. You MUST close the positions at expiration.)

Suppose you buy the call for $20 ($15 of intrinsic value + $5 of extrinsic value) Since you can sell your stock for $75 via the put when the stock is only worth $60 today, it also has intrinsic value of $15. Plus it expires in a year, so it has extrinsic value. Because of this, your put is probably also worth about $20. NOTE: There is a total of $10 of extrinsic value in these options that you can NEVER recover. Your profit is predicated ONLY on the increase in INTRINSIC value!!!

Suppose that, at expiration, the stock is $95. Again, there is no extrinsic value. The call can be exercised at $45, so it is worth ($95 - 45 =) $50. You paid $20 for it, so you made $30 on the call.

On the other hand, you're not going to exercise your put - why sell the stock to someone for $75 when you can get $95 in the market? So, your put is worthless and you've lost whatever you paid for it - in this case $20.

So, on balance, you made $10 on your $40 "investment" (i.e. 25%) IF (big "if") the stock moves up or down by about 60%!! Good luck.

Similarly, I could show that if the stock was worth $25 at expiration, you'd have made the same $10.

So now you're saying, "Big deal! If the stock is between $45 and $75, I lose the commission cost and $10 of extrinsic value I paid and the stock has to move $50 just to make $10. Whoppdy-do. I think I'll go to Vegas and play at the "21 Table".

Here's your problem:

You're buying options that are too deep in-the-money. Straddles are not intended to be that wide. For a straddle to work, one of the options must finish out-of-the-money. Let's close the gap and see what happens. Say your call is at $55 and the put is at $65 ...

Immediately, you're only going to pay $5 for intrinsic value. You'll also likely pay less for extrinsic value, but let's say you have to pay the same as in the previous example - $5. Each option will cost you $10 for a total commitment of $20. To compare "apples to apples", we'll assume the same stock price at expiration - $95.

Once again, your put is worthless, so you lose that $10. And again, at expiration the call option will have no extrinsic value. But it has intrinsic value! How much? $95 - 55 = $40. The call cost you $10, so you made $30 here. For an "investment" of $20, you made $30 - 150% return. Still want to go to Vegas?