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 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:
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. More on this topic in a future article.
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.
– 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) 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.
Another week of predominantly disappointing economic reports. The producer price index (PPI) for finished goods increased by 0.2% in July, housing starts rose 1.7% which was below expectations and unemployment claims rose to 500,000 higher than expected and the most since November. On a positive note industrial production rose 1.0% in July, better than anticipated and the Conference Board’s index of leading economic indicators increased by 0.1% in July. The total picture is that of a very slow and sluggish economic recovery. For the week the S&P 500 was down 0.7% for a year-to-date return of -2.7% (including dividends).
This week I have constructed a 3-month chart comparing the price action of the S&P 500 and the movement of the CBOE Volatility Index. In an ideal world we would like to see a slowly rising S&P 500 and a declining or stable VIX (under 30). Let’s look at the graph:
Note the following:
- The S&P 500 has been relatively flat over the past 3 months (red circle), a neutral indicator.
- Recently we see a downturn in market performance (red arrow), a bearish sign.
- The VIX has been declining by over 40% in the past 3 months (green circle), a bullish signal.
- The VIX has been on the rise lately (green arrow), a negative.
IBD: Uptrend under pressure
BCI: Neutral, anticipating a sideways moving market and selling I-T-M strikes for protection against market volatility.
The best in investing to all,