When studying option trading basics we learn the equation for option premium value is:
Premium = time value + intrinsic value
If the strike price is at- or out-of-the-money the premium is all time value. Another basic principle is that time value decreases as we approach expiration Friday. Unless the strike price is deep, deep in-the-money we would expect a decent amount of time value if the contract has 3 weeks remaining until expiration Friday.
Real life example
Recently a BCI member contacted me about such a situation when there was seemingly virtually no time value remaining for a slightly in-the-money strike. Let’s examine the trade:
Mid-March: RTN was purchased and the April $57.50 call sold
March 28th: RTN trading @ $58.59, $1.29 above the strike price
The option chain showed a bid-ask spread of $1.19 – $1.30, with apparently no time value. Here is that options chain:
It appears that either the stock is overvalued or the premium is undervalued. One event that would account for this is an upcoming ex-dividend date. Let’s check to see the possible dividend information for this equity:
The dividend ex-date is important because that is the date the owner must hold the rights to the stocks to be eligible for the $0.55 dividend. April 1st happens to be the next trading day after March 28th because of Good Friday and then the weekend. Now, when a dividend is distributed the value of the stock decreases by the amount of the dividend, $0.55 in this case. Therefore, the $1.25 option premium for the $57.50 strike was based on a share value of $58.24 ($58.79 – $0.55).
If your head is not yet spinning, let me take this one step further:
Time value on an underlying valued @ $58.24 = $1.25 – $0.74 = $0.51
Since the market is evaluating RTN @ $58.24, the $57.50 strike is $0.74 in-the-money, leaving $0.51 of time value or about 1% for the 3 weeks remaining. The downside protection of that 1% is $0.74/$58.24 or 1.3%. This makes a lot more sense than no time value remaining with 3 weeks until expiration.
Just prior to the ex-dividend date, the options market will value equities based on the current market value minus the dividend about to be distributed. When an options premium does not make sense based on our education and experience we must look for explanations before making trading decisions.
FREE WEBINAR FOR BCI MEMBERS: LIVE OR DELIVERED TO YOUR MAIL BOX:
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New feature to premium stock reports:
The BCI team makes every effort to respond to the needs and suggestions of our members. Several premium members requested publication of the specific risk-reward statistics. Although all stocks with rankings of 5 or higher ARE eligible some members asked to use the actual rank when deciding between equities that are otherwise similar. As of last week’s report we now post those figures as shown in the screen shot below:
Next live seminar:
April 20, 2013 (9AM- 12PM
- The economy added just 88,000 jobs last month below the 200,000 expected
- Jobs totals for January and February were revised upward
- The unemployment rate fell from 7.7% (the rate expected again) to 7.6% but mainly due to a decrease in the labor force
- Higher payroll taxes and the impact of the “sequester” are taking a toll
- The ISM Index (March) for manufacturing still indicated growth @ 51.3 but the rate softened as 54.0 was anticipated
- The ISM Index (March) for non-manufacturing also remained in expansion @ 54.4 but below the 55.8 expected by analysts
- Initial jobless claims for the week ending March 30th came in at 385,000 well above the 347,000 expected
- The trade deficit came in at (-) 43.0 billion, better than the (-)44.6 billion predicted
- Consumer credit in February rose to $18.1 billion above the $16.0 billion expected
- Construction spending in February was up 1.2%, better than the 1.0% predicted and 8% higher than one year ago
- New factory orders rose 3% in February higher than analysts anticipated
For the week, the S&P 500 declined by 1.0%, for a year-to-date return of 9.5% including dividends.
IBD: Uptrend under pressure
BCI: Due to the impact of the sequester and now the added uncertainty related to North Korea this site remains cautious in its covered call writing approach favoring in-the-money strikes. We still remain long-term bullish on our economy and the stock market in particular.