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Covered Call Writing: Factors That Affect The Value Of Our Option Premiums

So you sold an options contract for $380 and generated a 3.5% 1-month return. Did you ever wonder how the market determined the value of that options contract to be $380? The simple equation that most of us know and understand is the following:

 Option premium = Intrinsic Value + Time Value

To review, let me define the two latter terms using the definitions given in my books and DVDs:

Intrinsic Value– The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which the stock is in-the-money. For call options, this is the positive difference between the stock price and the strike price.

For example, let’s say that Dell Computer is trading for $22.50. The DELL 20 call option would have an intrinsic value of $2.50 ($22.50 – $20 = $2.50) because the option buyer can exercise his option to buy DELL shares @ $20 and then turn around and sell them at market for $22.50 thereby generating a profit of $2.50 per share. If we sold the DELL $25 call, the intrinsic value would be zero ($22.50 – $25 = -$2.50) because the intrinsic value cannot be a negative number. Therefore, only in-the-money call options have intrinsic value.

Time Value- The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever the value the option has in addition to its intrinsic value. Since all options (excluding quarterly contracts of some exchange-traded funds) expire on the third Friday of the month and time value varies significantly from stock to stock, let’s examine the factors that determine the time value of our call options:

1- Time until expiration– When trading options, time is opportunity. The longer the time frames until Expiration Friday, the greater the chance that the options will finish in-the-money. Therefore, an option buyer is willing to pay more for the increased opportunity and the seller will demand more for the increased risk that the additional time requires him to assume. The time component of an option decays exponentially. Approximately 1/3 of its value is lost during the first half of its life; 2/3 during the second half of its life. Here is a chart that depicts such time erosion:

Time erosion of an option premium

2-Volatility– This is the fluctuation, not direction, of a stock’s price movement. It represents the deviation of day to day price changes. It measures the speed and magnitude at which the underlying equity’s price changes.  There are two types of volatility:

  • Historical– the actual price fluctuation as observed over a period of time.
  • Implied– a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace.

These are the main factors that influence the time value of your option premiums. Two more but lesser factors are:

3- Interest Rates- As interest rates rise, the value of the call will increase. Cash spent on owning the underlying stock is opportunity (interest) lost, thereby increasing the value of the option.

4- Dividends- As dividends increase, call or option value decreases. This is because it is the option seller (who owns the underlying security) who collects the dividend distribution, not the option buyer.

As sellers of 1-month options, the main factors that affect the time value of our option positions are time until expiation and volatility. I mention the other two only in the interest of completeness.

To summarize:

– Time to expiration decreases…..Call value decreases.

– Volatility increases…..Call value increases.

– Volatility decreases…..Call value decreases.

– Dividends increase….Call value decrease.

– Dividends decrease…..Call value increase.

– Interest Rates increase…..Call value increases.

– Interest Rate decrease…..Call value decreases.

– Share price increase…..Call value increases

– Share price decrease…..Call value decreases

How to use this information:

The intrinsic value of the premium applies only to I-T-M strikes. I view it as the insurance policy the option buyer purchases FOR US. The best environment to take advantage of intrinsic value is in a mildly bearish or volatile market and when stock technicals are mixed.

When time value reflects a potentially volatile situation, we must assess market conditions and equity technicals to determine if that security will be part of our portfolio and if so, which strike to sell. Premiums with high time value (5-8%, 1-month returns for at-the-money strikes) will appear more appealing in bullish markets and when stock technicals are positive.

The complicated mathematical formulas that determine the precise option premium are not critical to our successful investing. I do feel, however, that having a basic understanding of the components that influence this price can only make us better investors and get us closer to our goal of becoming CEO of our own money.

Market tone:

This week’s economic reports re-enforced this site’s moderately bullish outlook for modest growth:

  • The Fed stated that it expects the unemployment rate to fall between 8.2% and 8.5% this year, a more bullish outlook than it had in November
  • The Fed projects economic growth between 2.2% and 2.7% this year, slightlty less than previously thought
  • The Fed predicts inflation to remain between 1.5% and 1.8% this year, below its target rate of 2%
  • The Fed announced that it would keep short-term interest rate near zero through late 2014, an extension of a previous projection
  • The Conference Board’s measure of future economic activity increased by 0.4% in December, higher than November’s 0.2% rise giving reason for cautious optimism
  • GDP for the 4th quarter rose to an annualized 2.8%, the strongest performance since the 2nd quarter, 2010
  • For the year, the US economy grew by 1.7%, down from 3% in 2010. This had a lot to do with debt issues in Europe, disasters in Japan and our bickering Congress
  • Durable goods orders rose by a better-than-expected 3% in December, the 5th increase in the last 6 months
  • New home sales fell 7.3% in 2011, a record low BUT 4th quarter sales rose an annualized 20% from the previous quarter and 3% higher than the same quarter in 2010 

For the week, the S&P 500 increased by 0.1% for a year-to-date return of 4.8%, including dividends.

In this election year we are and will be hearing doom and gloom scenarios regarding our economy. Politicians (both sides) will do and say anything to get a vote. This site evaluates market tone based on weekly economic reports, the status of the CBOE Volatility Index (VIX) and technical assessment of the overall market (S&P 500). We are aware that catastrophic events (hurricanes, war etc.) can negate the trends but we do all we can to maximize our returns and meet our goals. Creating fear is effective in compiling votes but ineffective in creating successful investment outcomes. When a politician speaks about our economy, I become the little boy who is being chastised by his mother: I put one finger in each ear and break out a chorus of “la-la-la-la-la”. 

This week I decided to take a broad look at the market since the sub-prime debacle and recession of 2008 to present day. I also present a graph of US GDP in that same time frame. The green fields represent the severe drop in the market in 2008 and the negative GDP and the yellow fields represent what has taken place since. Our economy is far from fully recovered. Unemployment, although improving, is far too high and the housing market must strengthen for a return to full economic recovery. When we risk our hard-earned money it’s important that we make our market evaluations based on the facts rather than on self-serving diatribes of others. We report, you decide:

GDP: 2008-2011

 

S&P 500: 2008-2011

 
 Summary:
 
IBD: Confirmed uptrend
 
BCI: Moderately bullish selling both ITM and OTM strikes
 
***We welcome and thank  BCIers to our growing population of premium membership and ALL our members for your continued support over the years. There will be many exciting enhancements to this site in the very near future. My team and I have been working furiously behind the scenes to make the BCI experience better than ever. You have put us on the financial map in a very big way and we will never forget that.
 
My best to you,
 
 
 
 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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30 Responses to “Covered Call Writing: Factors That Affect The Value Of Our Option Premiums”

  1. Tony January 28, 2012 1:46 pm #

    Alan,

    I’m trying to understand why an increase in dividends will result in a decrease in call value. Any help appreciated.

    Tony

  2. owen January 28, 2012 2:22 pm #

    Tony (#1),

    In a perfect math world a dividend will reduce the price of the stock by the dividend amount. Example: Assume the stock price is, dollar for dollar, equal to the company book value. If the company has a book value of $22 per share, and declares a dividend of $0.50 per share, the book value, and the stock market value, will decrease by $0.50 per share. Therefore,, again, in a perfect math world, an increase in the dividend will decrease the stock price even further. That, in turn, will decrease a call value.

    Now, we all know that the stock market does not operate in a perfect math world. If a company pays a dividend the stock could rise because of some other news, fall because everyone thinks they shouldn’t pay the dividend, or stay the same because nobody cared.

    So, it is not a foregone conclusion that a dividend will decrease a stock price, or a call price, but it is something to consider in your research on a stock for your covered call strategy.

    Be aware that an unusually large cash dividend, a stock dividend, or a stock split, will cause the options to be adjusted to compensate for the change. These have been discussed in other articles on this site. Look to the left for hyperlinks to take you to some of them. I can see “stock splits” and “stock dividends” as I type this response.

  3. Steve Z January 28, 2012 5:40 pm #

    Alan, since you’re working on a website improvement, here’s an idea for you.

    The check box at the bottom of the page only allows for notifications of follow-up comments if you post a comment.

    I’d like the ability to check a box to be notified of comments whether I’ve posted a comment or not, like they allow on Seeking Alpha.

    In SA’s, the box is for anyone to check if you want to track comments. Then if you post a comment the box is automatically checked. I like that system. It does the same thing yours does but with added capability/flexibility.

  4. Fred January 28, 2012 10:32 pm #

    Alan,

    I understand implied volatility and how it affects option premium but how do you factor historical volatility into your selection process?

    Thanks.

    Fred

  5. Barry B January 28, 2012 11:22 pm #

    Premium Members,

    The Weekly Report for 01-27-12 has been uploaded to the Premium Member website and is available for download. The report is in two parts…01-27-12-PartA and 01-27-12-PartB. Please be sure to download both parts.

    Best,

    Barry and The BCI Team

  6. admin January 29, 2012 5:56 am #

    Tony (#1),

    One additional point to add to Owen’s commentary relates to investor perception. Investors tend to value a stock that generates a dividend although Owen makes a great point that share value is actually reduced by the dividend amount. However, that divdend goes to the share owner NOT the holder of the call. To a very minor extent (as stated above) if the dividend increases owning the stock becomes more attractive than owning the call option.

    Alan

  7. FrankK January 29, 2012 9:34 am #

    I agree with the idea of being able to get the followup without posting here. Just allow us to check a box to get the email all the time.

  8. admin January 29, 2012 11:39 am #

    Steve and Frank,

    Thanks very much for your suggestion. As always, we make every effort to respond to our member needs. I will pass this recommendation on to my webmaster to see if it can be incorporated into our new web theme.

    Alan

  9. admin January 29, 2012 6:56 pm #

    Fred (#4),

    Since historical volatility is based on past performance rather than current market expectation we can select the stocks that give us the best chance of success in the current market conditions. In the BCI methodology one of the factors we consider is “beta”. This is the measure of volatility compared to the market as a whole. As a general rule, high beta stocks outperform in bull markets and low beta stocks outperform in bear markets. After running our stocks through the “major” BCI screens we can use beta to choose between the available candidates. This is the reason we include beta statistics in our weekly premium reports.

    Alan

  10. admin January 30, 2012 11:26 am #

    Expiration cycles:

    I’ve had a few offsite inquiries asking about a list that identifies the expiration cycles assigned to each stock. The only list that I am aware of is specific for securities with LEAPS but does include nearly 1000 equities. Here is how to access that list:

    http://www.optionseducation.org

    • Trading tools

    • Market data

    • Product specifications

    • LEAPS

    • Complete LEAPS

    For our premium members, I have archived this information in the “resources/downloads” section of the premium site so it can be accessed at any time. Look for the file titled “Expiration Cycles for Stocks with LEAPS- How to locate”. If any of our members know of a more inclusive list we’d love to hear from you.

    Alan

  11. Barbara January 30, 2012 4:37 pm #

    Does anyone know if there are any new tax considerationms related to stocks and options that we need to consider for 2011? Thanks for any assistance.

    Barbara

  12. Rocky January 31, 2012 6:36 am #

    Alan,

    I’m a new subscriber to the premium membership and wanted to know if you consider institutional ownership of stocks in your weekly list. Is there a place I can access this information?

    Thanks for a great service.

    Rocky

  13. Will January 31, 2012 8:00 am #

    I think the chart you used to depict time value erosion is incorrect! Time value is not linear as your chart shows. The closer you get to expiration the faster your time value deteriorates. It looks very different than the chart you display….

  14. owen January 31, 2012 10:15 am #

    Barbara (#11)

    Yes, there are.

  15. owen January 31, 2012 10:22 am #

    Ok, enough jocularity. There has not been any changes in the laws regarding how you calculate your gains, but there has been significant changes in the reporting by brokers and the forms you use to report your gains on your tax returns.

    Alan has asked me to prepare a tax discussion, as I did last year, to run as the weekly post. I am working on it and it will be posted in a couple of weeks. You should begin receiving your 1099 reports from brokers and banks in February. Make sure you keep them safe for your tax preparer.

  16. admin January 31, 2012 1:30 pm #

    Rocky (#12),

    Institutional ownership IS factored into our investment decisions. One of our screens the IBD SmartSelect screen has 6 categories. One is titled “Acc/Dis Rating”. It tracks the relative degree of institutional buying (accumulation) and selling (distribution) in a stock over the past quarter (13 weeks). If you would like specific information on institutional ownership check the “resources/downloads” section of the premium site and scroll down to “Institutional Ownership- How to locate”.

    Thanks for your kind words.

    Alan

  17. admin January 31, 2012 1:35 pm #

    Will (#13),

    Actually the purpose of the chart was to demonstrate that the time erosion IS logarithmic rather than linear. As I stated directly above the chart:

    “Approximately 1/3 of its value is lost during the first half of its life; 2/3 during the second half of its life”. Perhaps the arrows I created muted the intended affect of the graph.

    Below is the same chart without the arrows. The yellow field shows the amount of time erosion in the first half of the contract cycle and the green field shows how much greater that erosion is in the second half of the cycle. We are in full agreement.

    Alan

  18. admin February 1, 2012 9:58 am #

    Running list stocks in the news: LULU:

    This high-end yoga clothing company has a market cap of $7B and earnings growth of 50%. On January 10th, CEO Christine Day increased 4th quarter earnings guidance. Sales increased by 31% year-to-year. Analyst consensus is for earnings growth of 58% in 2012 and 28% in 2013. LULU has a history of responding well after ERs. Our premium watch list shows an industry rank of “B” and a beta of 1.35. 1st quarter earnuings is projected to be on March 15th.

    Alan
    Alan

  19. djswett February 1, 2012 12:32 pm #

    Good day, Alan,

    You have mentioned your working on a new web site and premium report rewrite.

    May I suggest that you share mock-ups of your prelininary design and concepts; there are a lot of BCI/industrial engineer types who would be more than willing to contribute ideas for your designer.

    David

  20. GDC February 1, 2012 12:54 pm #

    Probably just preaching to the choir, but there’s a recent article in Barron’s on the buy/write strategy. I wonder if there are any new findings/insights in the Goldman Sachs study that’s referenced. Has anyone read it?

    http://online.barrons.com/article/SB50001424052748704895604577179021942415512.html#

  21. admin February 1, 2012 6:33 pm #

    David (#19),

    Thanks for your very generous offer. Our new site is near completion and should be launched shortly. I will be getting a conference call update this Friday. We do value the feedback from our members and many of the features you see today on this site and in our reports have been the result of the constructive advice from members like you. I have no problem making changes even after the new theme is launched. I encourage all our members to share your ideas. We need and value this feedback. This is OUR site…

    Alan

  22. admin February 1, 2012 6:51 pm #

    GDC (#20),

    I’ve been told of the Goldman finding by folks who work there. Obviously no surprise to us. What is noteworthy regarding this report and many others like it is that they write slightly OTM strikes only (we use ALL strikes). They are usually written against a benchmark (we select very specific stocks with great fundamentals, great technicals and meet our common sense requirements (minimum trading volume etc.). In a typical study, no exit strategies are used. Despite these shortcomings, the results are so noteworthy that Barron’s published an article on the results. You called it right…preaching to the choir.

    Alan

  23. admin February 2, 2012 8:10 am #

    Running list stocks in the news: UTEK:

    This stock has been on our premium watch list for 6 weeks. On January 26th the company reported its 5th straight positive earnings surprise. Revenues rose from 43.6M to 56.1 M and earnings from $0.25 to $0.42/share. Historically UTEK has a strong price performance after earnings. Our premium watch list shows an industry rank of “A” and a beta of 1.51.

    Alan

  24. Rocky February 2, 2012 8:13 am #

    Alan,

    In your ETF report you state “has an RS rating of 70 or better”. Can you explain.

    Rocky

  25. admin February 2, 2012 2:45 pm #

    Rocky,

    RS Rating relates to the relative price performance of these securities. An RS rating of 70 or better means that each ETF in the report has outperformed 70% of other securities over the 3-month time frame. Of course, it is no guarantee of future price performance but does show strong momentum and institutional support.

    Alan

  26. admin February 2, 2012 2:59 pm #

    “Banned Stocks”

    ANF announced its same store monthly retail stats today…down 11%! Keep the list adjacent to your computer at all times. Premium members: these stocks are screened out for you.

    Alan

  27. Steve Z February 2, 2012 4:17 pm #

    Unwind Now Tab Question

    I’m happy that I have several of my February expiration positions that should be considered for the “Mid-Contract Unwind” strategy.

    Since I’ve been a member for less than a month and this is my first unwind opportunity, I studied the Unwind Tab in the calculator and pages 264-269 in Alan’s Encyclopedia. I concluded that I still need to do a mental calculation for the remaining time value of the contract as it doesn’t seem to be explicitly spelled out in the calculator.

    Since this remaining time value in the contract is the key decision-making data to decide whether to pursue the mid-contract unwind approach or not, I wanted to have it spelled out for me in the calculator.

    To do this, I added a couple of simple calculations to get the original profit, the remaining contract time value, and the percent of max profit that’s been achieved.

    I attached a jpeg of the example from the Encyclopedia with my additions.

    Alan &/or Owen, I’d be interested to know if there is a flaw in my thinking or conversely why you decided to not include in the calculator what seems like the key calculation/data point. If I’m going to start using this I want to be sure I’m thinking about it correctly.

    Your perspective would be greatly appreciated.

    Steve

  28. admin February 2, 2012 6:28 pm #

    Steve,

    First let me congratulate you for being in this situation. It means that you have selected great equities and maximized or nearly maximized your 1-month profits PLUS in a position to set up a second income stream with the SAME cash in the SAME month. I love it!

    I appreciate your suggestions about the new additions to the “unwind now” tab of the Elite Calculator. I can see where many of members
    will find this useful information. We are fortunate to have members like you offering constructive ideas and after our new site is launched (soon!) I will meet with my team to discuss these ideas including yours.

    You are spot on with your assessment of this strategy. I would, however, put slightly more emphasis on the relationship between the time value spent to close the original position as it relates to the time value generated in the new position than on the percent of maximum profit achieved. That’s why I never put a specific percentage to maximum profit percentile but rather stated it in my book as follows:

    “The keys are that the time value of the option premium must be close to zero, and the new position must generate more cash than the amount of time value spent to close the original position”.

    I must admit that I always did the time value remaining in my head as I viewed the options chain (see below) as shown on page 266 of “Encyclopedia….”. The red and blue circles show the $11 you have memorialized in your additions.

    At that point I look for trades that can generate more than the $11, hopefully a lot more. I will speak to my team about your ideas as I feel they can be helpful additions to the calculator. Thanks for the feedback.

    Members: You can view the images by clicking on them and then using the back arrows to return to this blog.

    Alan

  29. admin February 3, 2012 10:56 am #

    Radio interview:

    An interview I recently participated in with Danielle Hampson of The Business Author’s Show is currently being replayed at the following link:

    http://www.TheBusinessAuthorsShow.com

    Alan

  30. Steve Z February 6, 2012 9:35 am #

    Alan, sorry to keep asking questions about this mid-contract unwind strategy but I really want to internalize it.

    In the calculator example which we discussed above and which came from the Encyclopedia, there are a series of calculations required to get to the net Gain (Loss) to Unwind of $89. There are also the calculations required to get to the original $100 per contract profit. We then take the difference between these two calculations to get the $11 we are spending to unwind the contract. Lots of calculations and the calculator can be very helpful to speed our way through them.

    On the other hand, as you wrote above, we can also get to the $11 by just taking the difference between the Ask price and the Intrinsic Value and multiplying by 100. This is a LOT simpler than doing all the calculations in the calculator and seems to get us to the same result.

    My question is whether this result is always the same whether we calculate it the long way or the short way or is it just a coincidence of this example?

    I’ve tried other examples and it seems to always be true but I ask the question because it isn’t intuitively obvious to me. The intuitively obvious way is to use the calculator and determine the difference between the original profit and unwinding the original contract.

    The short way doesn’t require knowing the original purchase price of the stock nor the original sale price for the option and so doesn’t need the original profit calculation. All it requires is the current Intrinsic Value and the Ask price making all the calculations to get to the $89 and the calculations to re-create the original profit completely unnecessary.

    So again, it seems to work but it isn’t intuitively obvious to me. Given how simple the calculation is, I suspect I’m over-thinking this and there’s an equally simple explanation.

    Thanks in advance for your perspective.

    Steve

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