AMC Entertainment Holdings, Inc. (AMC) closed today at $14.52, down more than 50% from December 21's close of $30.30. As stock prices fall, put option values increase. Options consist of two components. They are Intrinsic Value and Time Value. Intrinsic Value is how much the option is worth at expiration. Intrinsic value for a particlular Strike Price is the same regardless of the expiration date. The remaining value is Time Value. There are many factors that determine Time Value. Time Values vary because of time to expiration, interest rates, and for this case study, Implied Volatility.
Although the calculations of Implied Volatility are complicated, the concept is not. When there is a greater chance of price movements, option buyers are willing to buy options hoping to hit the home run. Instead of buying or shorting a stock, they can control shares for less money by buying call options or put options. The more chance of big price movments, the more risk option sellers face. Option prices inflate because option sellers want more to face that risk. Option buyers willingly pay more because their perceived chances of price movements in their favor increase.
Back on September 18, 2018, Who Owns The Big Buildings described characteristics of the insurance industry and discussed how they can be applied in the stock marketing world. Put options are basically insurance for stock. The financial community has spent a lot of time and money trying to convince people that they are too stupid to take care of their own money. Many people don't even know that insurance exists. They take their chances investing in stock and when they lose too much, they pay someone else to take care of their retirements. In the YouTube video entitled "Waaay Better Than Covered Calls", it showed how to buy stock with unlimited profit potential while limited losses to 5%, by also buying put options as insurance.
Whether talking about pizzas, food, or insurance, it is the seller of the products that make money, not the buyer. The plan is to Sell To Open 1 contract of AMC put options that expire on July 15 and have a strike price of $5.00. By Selling To Open 1 July 15 $5.00 put, currently $.40 x $.45, there is an obligation to Buy To Open 100 shares of AMC at $5.00 per share until the option expires at the end of trading on July 15. If the Bid price of $.40 is collected tomorrow, this would be all profit as long as AMC stays above $5.00. If AMC drops below $5.00 there will be a penny for penny gain in Intrinsic Value as the stock price drops. This means a penny for penny loss for put sellers. If $.40 is collected, AMC could drop to $4.60 before any loss is realized. Because there is an obligation to buy shares at $5.00 and AMC could go bankrupt and be worth zero, there could be a chance that shares are Bought To Open at $5.00, and Sold To Close at $0.00. Therefore, there is a maximum risk of $5.00. Because $.40 is collected up front, the risk is reduced to $4.60. A $.40 gain on a $4.60 risk is almost a 10% return.
Like real insurance companies that sell policies, bundle them, and sell them to someone else to reduce their risk, the plan is to Buy To Open 1 July 15 $3.00 put, currently $.13 x $.17. This would cost $.17 to bring the risk down to $2.00. That's because selling the obligation to buy shares at $5.00 and buying the right to sell shares at $3.00, means the maximum risk is $2.00. The transaction would bring a net credit of $.23. If at the end of July 15, $5.00 < AMC, both options would expire worthless and a $.23 profit with $2.00 placed on hold means more than a 10 % gain.
An option's Delta can be used in two ways. Delta approximates how much an option value increases or decrease for every $1.00 increase or decrease in the stock price. Delta can also approximate the probability that an option will expire In The Money. In this case, the Delta of July 15 $5.00 puts is .0451. Mathematically, this Bull Put Spread has a 95% probablitiy of success and a 10+% return.
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