Many option traders will look to make money as a result of a discrepancy between an option’s current market value and its theoretical value. In other words, is the option overpriced or undervalued? If, for example, an option is calculated to be underpriced an investor will purchase it and look to sell it when market forces return it to the higher, more appropriate value. An analogy would be if you found a real estate property on sale for $100k in an area where similar homes were selling for $120k…buy low and sell high. In order to utilize this approach, we would first need to determine the theoretical value (a mathematically derived estimate of the value of the contract) of the option to determine if it is priced fairly.
The most well known of these option pricing models is the Black-Scholes Model introduced by Fischer Black and Myron Scholes in 1973. The following option and underlying characteristics need to be known for the calculations:
Parameters used for the Black-Scholes Model:
- The option’s exercise price
- The current price of the underlying
- The risk-free interest rate over the life of the option
- The amount of time remaining until expiration
- The volatility of the underlying
These parameters are entered into the formula developed by Black and Scholes and a theoretical value for the option is calculated and then compared to the current market value. There have been several variations of the Black-Scholes Model developed since 1973 but the original remains the most popular amongst traders. There are several assumptions made by this model some of which have come under criticism:
Assumptions of the Black-Scholes Model:
1) The stock pays no dividends during the option’s life
Many companies do in fact distribute dividends which may impact call premiums. One way to adjust the model for this would be to subtract the discounted value of a future dividend from the stock price. Even though the original Black-Scholes model does not take dividends into consideration, an extension of the Black-Scholes Model proposed by Merton in 1973 alters the Black-Scholes model in order to take annual dividend yield into consideration. This model is not as widely used as the original Black-Scholes Model.
2) European exercise terms are used
The model assumes that the option can only be exercised on the expiration date. We, in fact, use American style options which allow the option to be exercised at any time during the life of the option, making American options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you lose the remaining time value on the call and collect only the intrinsic value.
3) Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The Black-Scholes model assumes stocks move in a manner referred to as a random walk. Random walk means that at any given moment in time, the price of the underlying stock can go up or down with the same probability. The price of a stock in time t+1 is independent from the price in time t.
4) No commissions are charged
Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that individual investor’s pay is more substantial and can often distort the output of the model.
5) Interest rates remain constant and known
U.S. Government Treasury Bills 30-day rate can be used since the U. S. government is deemed to be credible enough. However, these treasury rates can change in times of increased volatility.
6) Liquidity. The Black-Scholes model assumes that markets are perfectly liquid and it is possible to purchase or sell any amount of stock or options at any given time.
7) Returns are lognormally distributed (normal distribution of the log of the returns).
This assumption suggests returns on the underlying stock is normally distributed, which is reasonable for most assets that offer options.
Effect of changing market conditions on an options theoretical value:
1) As the stock price rises, the call value rises and the put value falls and vice versa.
2) As volatility rises, call and put value rise and vice versa.
3) As we approach expiration Friday (time passes), call and put value fall.
4) Rising interest rates will cause calls to increase in value and puts to fall in value and vice versa. When interest rates are high it costs more to buy the stocks (cost of carry) and therefore calls become more desirable.
5) As dividends increase, call value declines and put value increases. If dividends increase we prefer to take a short position by buying a put rather than selling the stock.
The historical volatility is the volatility of a series of stock prices where we look back over the historical price path of the particular stock. To enable us to compare volatilities for different interval lengths we usually express volatility in annual terms.Volatility is simply the standard deviation (will occur 68% of the time) of the sampled series (over how many intervals). If, for example a $60 stock has a historical volatility of 20%, it will fall in the range of $48 – $72, 68% of the time (one standard deviation) in one year.
Conclusion:
The method used by most options traders to determine the theoretical value of an option is the Black-Scholes Model. Certain parameters are fed into the equation and several assumptions are made to calculate the figure. It is important to understand the strengths and weaknesses of this model as we apply it to our investment strategies. For covered call writers it is more important to understand the relationship of the parameters to option and stock value rather than actually calculate theoretical value which is of more value to the traditional options trader.
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Market tone:
This site has been consistently bullish on the US economy for the past six months and still remains so. However, global concerns for Libya, Japan, Yemen and other areas have negatively impacted out stock market. This past week again favored positive news for our economy:
- The FOMC policy statement upgraded its economic outlook: “….overall conditions in the labor market appear to be improving gradually,” the Fed announced
- The target for fed funds remained @ 0% to 0.25%
- The plan remained in place to purchase $600B in Treasury bonds to help support economic recovery
- New construction fell 22.5% and building permits dropped 8.2% with housing once again not joining the party
- The Conference Board’s index of leading economic indicators rose 0.8% in February
- Industrial production fell 0.1% while manufacturing production rose 0.4% in February
- The core rate of inflation rose 0.2% in February, an acceptable amount
For the week, the S&P 500 fell by 1.9% for a year-to-date return of 2.2% including dividends.
Summary:
IBD: Market in correction
BCI: This site remains cautiously bullish but because of the global turmoil is restricting covered call sales to in-the-money strikes.
Much success to all,
Alan,
I can”t count how many times I read about the Black Scoles model but never really understood how it worked. Thanks for another wonderful article.
Barbara
It seems to me that if we use the current value of the option and all other parameters except the historical volatility, we can use this model to get the implied volaitlity. Does this make sense?
Fred
The problem I have with math models that try to explain, or predict prices, is similar to the aeronautical engineers that claim bumble bees cannot fly. They are not aeronotically designed to fly, but, since the bumble bees don’t understanc engineering, they fly, anyway.
You can plug all the math you want to determine the current value of an Apple option, or a Netflix option. Then throw in a news report that Steve Jobs is in the hospital, or Jim Cramer just announced that everyone should sell at least half his, or her, Netflix, and your model couldn’t get 1 to equal 1 on a good day.
Yes, the math may say the call is worth $1.72, and it currently $1.64, but, unless you are trading hundreds of contracts a minute, against other computers doing the same calcualtion, the “model” value really isn’t worth two cents.
Our covered call system relies on a continued trend for the next four weeks. The stock meets all the screen tests (because everyone likes it right now) and we are just hoping that they will continue to like it for one more month. That’s all. “The trend is your friend”.
Black-Scholes cannot exlain why a stock will drop $10 when the company anncounces record earnings. It still comes down to this: “anything is worth ONLY what someone else will pay you for it, right now”. This applies to stocks, houses, cars, Big Macs, gasoline, etc. Take the Mona Lisa to the African jungle and try to trade it for a cow. Bet you’ll get no takers. Offer to trade a Big Mac for two pound of gold to someone who hasn’t eaten in four days, and can’t find any food. Guess what the Big Mac is worth? Reverse it. Offer a pound of gold to a guy who just got a Big Mac after four days without eating. Guess which he thinks is worth more?
I’ve had my good days, and my bad days, but I will stick with just trying to stay a little ahead of the pack. I will keep letting the lions kill the gazelles, and I wll try to sneak a piece here and there, when they aren’t looking.
Premium Members,
The Weekly Stock Screen and Watch List for the week ending 03-18-11 has been uploaded to the Premium site.
Best,
Barry
Curious what site you use to get the 1 month price chart of an option that you used in your exit strategies book. Thanks for all your GREAT stuff!
Alan,
Can you give more information on the cost to carry as it relates to interest rates. Thanks also for this excellent article.
Jeff
Fred (#2),
You are spot on. Since the parameters other than historical volatility will be the same no matter which calulation you are doing, using the current market value of the option will ABSOLUTELY allow you to solve for implied volatility. For new members, the IV relates to the market expectation of the volatility of the underlying over the course of the option period. If, for example, there is an upcoming earnings report or anticipated FDA approval or denial of a new drug, IV will be much greater than the HV. Great point!
Alan
Linda (#5),
Here are 4 sites to access historical options data (2 FREE, 2 PAY):
Historical Options Data- access option price charts
FREE sites
1- Go to
http://www.dailyfinance.com
• Enter the stock symbol for quotes
• On the left of the quote page you will see a hyperlink “option chain”
• When you see the option list, each of the options will be a hyper link
• If you click on the option symbol a small window will pop up with details, including a graph
2- Go to
http://www.cboe.com/DelayedQuote/AdvChart.aspx
• Enter the stock symbol in the upper right corner of the “company data” portion
• Click on “options chain” just above the company chart
• Select the expiration month you want
• Then click on the option description to show the chart for that option
PAY sites:
1- Go to
http://www.cboe.com
• Click on “quotes/data”
• Click on “market data express”
2- http://www.investools.com
Alan
A reminder about Linda’s link to dailyfinance: it’s actually a terrific site for free. Besides having decent option chain details, and advanced charts, the “Quote Details” section give you the next earnings report date, the current short interest of the stock, the total number of shares outstanding (important for determining the percentage of short interest), the next EX-dividend date (important if you want to capture the dividend), latest news (by the minute), and a number of other very useful pieces of information. Amazing for a free site.
The part I find absolutely amazing is that it give you the actual REAL TIME quote, just below the 15 minute delayed quote. Are you kidding me? How useful is that for trading options? I don’t need to know what the stock was 15 minutes ago, I need to know NOW.
Want to keep an eye on AFTER HOURS trading? Try the CNBC (free!) website: http://data.cnbc.com/quotes/
Jeff (#6),
As interest rates rise our option premiums also rise. This is because we will now pay higher interest in margin accounts making it more appealing to own lower-cost options over the shares themselves. Also, cash that would normally be invested in stock can be earning the higher interest rates also making options more valuable.
Alan
Hello Alan,
I want to thank you for these weekly articles, you have a knack of teaching through illustrations that are simple and to the point. Without you I would have been in the market at about 40% invested since October instead I’ve been in the 90′s. The reason is because I’ve been expecting a correction but CC’s and exit strategies give me the
confidence of cover.
This month I purchased and sold 10 contracts of LO ITM made $1.30 on the div. and .75 on the premium. Another group 8 contracts OTM, $1.30 div. $2.17 premium and made another $1.50 on the stock appreciation. Total hit about $5800. I took more risk than prudent with menthol in play and way more than 10% in any one stock. I will not do it to that extreme again, sleep problems.
I have traded LEAPS, 3-4 month out and your way- one month out. You win, I’ve discovered many reasons and thank you for it. I’ve traded aapl since 2006 $55/sh to $280 and made 27k, since trading options $280 to now $330 I’ve made 41k. This is an amazing stat but true, I went back and did the calc’s.
A question, what do you think of going after REITS on the month of dividend? Many pay 3-4 % per payment. Sell an ITM for protection, I’ve found a few that are stable and interesting.
Once again thanks to you and your team, you make a difference in peoples lives.
Phil from MA.
Phil,
The success of your strategy hinges on whether your shares are assigned the day prior to the ex-dividend date. This will depend on two factors (assuming the option holder is awareiof the dividend!):
1- Is there time value remaining on the option? If yes, you are less likely to be assigned.
2- What is the delta of the option? The closer to “1″ the more likely assignment will occur.
There is a lot of interest in the BCI community for this type of strategy. As a result, I am in the process of writing a more detailed journal article on this subject and plan to publish it on this site in the near future. I will also include it in my upcoming book.
Thank you for your generous remarks.
Alan
ULTA:
This company reported an 11% earnings surprise on March 10th with revenues up 20%. This pushed the share price to a new 52-week high. Estimates were also raised. Check to see if this equity deserves a place on your watch list and if so, use technical analysis to determine buy-sell decisions.
Alan
Hello Alan,
Thanks for your answer, as always to the point. I think I have it, someone out there picks up my option minutes before the close before ex-div. and uses my CC as protection to pick up the dividend. They pay a fraction of the div. on the CC and buy sell fees. They own the stock from the day before ex-div @ 3:50 to assignment.
I’ve been discovering this the last couple of months losing my div. and being assigned. The time premium, if there, cuts too far into their profits.
I look forward to your next book. Phil from MA.
Barron’s ran an article ranking online trading companies for price, service, etc. OptionsExpress ranked very well, and I have been very happy with it. Schwab announced that it is buying OptionsExpress. I have a Schwab account for one reason, and an OptionsExpress account for another. I hope this doesn’t mess up OptionsExpress.
http://www.cnbc.com/id/42191609
Can you explain why the dividend of some stocks change from time to time on the weekly report?
Thank you.
Jeff
Jeff,
The premium report highlights dividend YIELD, not the dividend itself. For example, if the dividend generated is $1 per share and the stock trades @ $50, the yield is 2% (1/50). If the price of the stock drops to $40, the yield becomes 2.5% (1/40).
Alan
Just wondering if any of our members are staying on the sidelines until all this global turmoil slows down. I’ve sold a few in the money calls but may hold off on the rest of my cash.
Amy
That would be me, Amy! :>)
I am still holding on to SWKS, which I failed to sell at the 8% loss point.
Other than doing some very far OTM, monthly index spreads, I am waiting on the sidelines and try to do my taxes.
Cheers
Dirk
Amy,
I’m in 100% this month and like you sold only in the money options.
Good luck.
Joe
Check out these stocks:
PII
HOC
HLF
Look good for covered calls.
Fred
I have read that 70% of a stocks price move is based on the overall market. Given the current world events my feelings are that it would be prudent to stay on the sidelines until these matters are resolved (hopefully).
Barbara
Barbara,
I fully understand your position. I wonder if and when world events will ever be calm. I am writing in the money options with a goal of 2% per month. Good luck to all.
Joe
Anyone trading the Powershares? FYI This message was on my Schwab opening page:
Important information regarding POWERSHARES QQQ TRUST (formerly symbol QQQQ)
On Wednesday, March 23, 2011 the POWERSHARES QQQ TRUST will undergo a symbol change from QQQQ to QQQ. All open Good To Cancel orders under ticker QQQQ will be cancelled. New orders received after market close on Tuesday, March 22, 2011 will be moved over to the new symbol “QQQ” and sent to the exchange.
I’ve read the books and done some paper testing. I know one can never do too much paper testing, but this week I’m thinking of take a position or two and wanted to get some confirmation from the group.
It appears to me that the only white stocks on the 3/18/11 Watch List paying anything are:
OPEN
VSEA
Wednesday’s movement helped both technically and both appear to have 2%+ ROO at ITM strikes and OK downside protection. Am I reading the list and doing the calculations correctly?
Barbara (#22),
I’ve been doing well with exchange traded funds. Once the market settles I’ll go back to individual stocks.
Jeff
Eric (#25),
Use the “Multiple Tab” of the Ellman Calculator to determine your option profit (ROO) and downside protection of this profit for your in-the-money strikes. I ran the numbers after market close today for the two stocks you are looking at. In the red oval is the profit for the remaining 3 weeks and in the blue oval is the percentage protection of that profit. See the chart below (click on chart to enlarge and use the back arrow to return to this page).
Alan
Premium members:
This week’s report of top-performing ETFs has been uploaded to your premium site. THE REPORT HAS BEEN ENHANCED TO INCLUDE MORE COVERED CALL CANDIDATES. New members: if you didn’t receive a direct email notifying you of this upload, please let us know and we’ll add your name to the premium mailing list. Premium members, who have changed their email addresses and do not receive direct emails, send your updated address to:
info@thebluecollarinvestor.com
For your convenience, here is the link to login to the premium site:
http://www.thebluecollarinvestor.com/member/login.php
Alan and the BCI team
EZPW:
I looked into the news about this company when I saw an impressive price acceleration with volume confirmation. The momentum indicators are also positive (see the chart below). This corporation operates pawn shops which also provides collateralized loans, a major need in this economy of so many unemployed. On March 10th it announced a partnership with Rev Worldwide which develops prepaid debit cards and the stock took off to the moon.
EZPW is now trading at a 5-year high but still trades at a reasonable 12.5 forward earnings. It boasts a price-to-book of 2.5 (we want it under 3) and a ROE of an outstanding 20.8%. It also produced a stellar earnings report on January 20th. Click on the chart below to enlarge and use the back arrow to return to this page.
Alan
Eric (#25),
Looks like your stocks are doing well especially OPEN up $4 today. Good luck.
Fred
I know this goes against the conservative philosopy of the BCI, but I would like to get a view point on this strategy. I find many small cap medical companies that have high premiums on CC’s . Upon further digging one finds that they have FDA meeting set for that month. I know its like selling CC’s during an earnings period. Let’s say one feels that this FDA approval is likely and does a buy/write on it. However, there is the possibilty that it may fail. In either case the stock is probably going to gap. My strategy is to place an advanced order on it. Set the trigger at your breakeven point or nearest strike point and buy Puts. Of course this will be done automatically by your brokerage firm. It seems pretty safe to me . What are your views?
Bill
Bill,
The danger is that the gap will not execute an order at the price you specified. If I own a stock that is currently $125, and put in a stop loss at $115, that stop loss will get executed if the stock falls below $115. Unfortunately, if the next price of the stock is $97 on a $30 gap down, my stop loss will get in at $97, not $115.
Apple is a good example. It closed Jan 14 at $348. Jobs announced his latest health problems on Jan 17. The next morning the stock opened at $329. If you had a $340 stop loss, you would have gotten executed at $329. The stock closed the day at $344.
Bill (#31),
In this case, you might want to look at a “Collar” strategy. With a collar, you add a protective long put to the covered call.
If the FDA announcement is positive, you make money on the covered call. If the FDA announcement is negative, you exit the covered call and make money with the put.
Another wrinkle you can add is adding a long call above your covered call price in case the stock gaps up passed your short call strike price. That way, you’ll make money on the covered call assuming it is assigned, you get the upside of the gap up with the long call, and you get your insurance with the long put (from your collar). Of course you would sell your long put when the positive news came out from the FDA.
Barry
OK, OPEN seems to be on the right track (along with every other Groupon competitor). I can only hope for a roll out and up here.
Now for newbie question #2.
When does the money from the option sale show up in my account?
In my account’s Transaction History it shows the proper debit and credit for the stock purchase and option sale. However, on the Balances and Positions page my overall account balance is virtually the same and the option shows as a loss that’s growing as the stock appreciates (yikes!).
Without getting too deeply into the details, why has the option sale not credited to my account balance and when will this all be reconciled (at expiration?)
Thanks again.
Eric,
Your account statement when opening a covered call trade:
Cash balances are decreased by the cost of the stock plus commissions minus the profit from the sale of the option.
Account values, however, will reflect a debit regarding the sale of the option, and will appear with a minus sign (-). This is because the calls may eventually be bought back, and thus are considered a liability until the option is exercised (causing you to sell your stock), bought back (closed) or the option expires worthless.
Alan
Thank you Owen and Barry B for your advice.I have a second part to this question. I believe, as Barry stated, I am doing a “collar” strategy. I have an advanced order set to purchase puts if the stock fall in price.This will be done automatically by the brokerage firm. If the stock is presently $20.00/share and I have an advanced order set at $18.00 Apr 11P, what are my chances it will hit this price and not go past it as it could in a stop loss?
Thanks,
Bill
Bill (#36),
The way I enter a collar is to buy the put when I buy the stock. This is called a “married put”. If you buy the put when the stock price is going down, the price of the put will be going up and cost more than if entered as a married put. Doing it up front, you know what your costs are and what your risks are. This will let you sleep at night.
Once the collar is established, you can then adjust either the short call or the long put as necessary as the Mr. Market demands.
Barry
Bill (#36),
One other point, by buying the put when you buy the stock (for a married put) before sell the call will define what your downside risk will be immediately. By selecting the put strike, you define what your loss, if any will be right up front. Then you can select the short call strike price depending on what your risk profile is.
Barry
Alan,
Is there any reason not to put the Bond portion of my portfolio in Bond ETF’s and sell covered calls on them?
Mark T.
Mark,
Impressive idea. I absolutely believe in having a bond segment to my overall portfolio as boring as that may be. Depending on your SPECIFIC situation, there may or may not be tax advantages or disadvantages to doing this. This is something you should address with your tax advisor. I can make the following observation:
If you can find a bond ETF (with options) that reflects your goals and portfolio makeup, selling covered calls on this (these) fund (funds) will more than likey increase your returns in the long run. This is much like “portfolio overwriting” where an investor writes calls on an existing portfolio of securities to generate additional income and create additional protection.
Thanks for sharing your idea with our members.
Alan
Mark T,
I agree with Alan. I would caution people who go this route that “what you see may NOT be what you get”. It is important to look into the ETF and see what it holds. I checked out a few. One is a bond INDEX fund which rises and falls with an index. Some hold actual bonds, but might hold too many high yield corporates. Some may “juice” there returns with leverage, which can come back to haunt you. Last, but not least, they pay a dividend, not interest. I believe, that the dividend is not not qualified, so you do not get the 15% rate you would on, say, CAT or JNJ.
On the other hand, most seem to pay monthly dividends, so it looks like you could play the dividend capture game every month, and make a few extra bucks on the options.
Just remember, the “F” in ETF stands for FUND, with any fund, there is a reason why the best fund is the best fund, and the worst fund is the worst. Look behind the name, which is often very misleading. The holdings are important, and so is the manager.
Barry B (38)
I see the logic behind a “married put.” I have another leg to my question. If a stock is waiting for FDA approval I would not invest in it, unless I felt the odds were in favor of approval. If it passes and I did a “married put,” the stock would gap upward and I would be happy. However, when I go to sell my put it is going to be worthless because of the gap. In this case,the advanced order to purchase the put, would not be triggered and I would have saved the monies on the put. On the other hand, if the stock fails, I will have to pay more for the put than if I bought it initially, but the stock is going to continue to gap downward and the put will increase in value . Of course I would of also been out of the stock and CC at that time. Feel free to punch holes in this theory.
Thanks
Bill
Bill,
Paper trade your theory for three or four months. If it works, it works, if it don’t, it cost you nothing.
That’s my two cents worth.
Hello Alan,
I have been trading for months a portion of my portfolio with ITM stocks that are paying dividends. I get assigned at times and sometimes it seems so arbitrary. This month I put out a buy/write experiment.
My trade was BMY ITM @ 25. My shares in an IRA were not assigned, so I collected the div. My shares in my taxable account were assigned losing the div. I purchased the stocks and sold the calls for the exact same amount in both accounts.
I would appreciate your thoughts on the matter and anyone else who has an opinion.
Thanks, Phil from MA.
Everything we are told is that it is arbitrary, Phil. There really isn’t a large open position for BMY APR 25 calls, so, if someone pulls the trigger early, there is a good chance of being the target. I guess it’s better the IRA kept the shares, and the dividend, if one of you had to get called.