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Option Premiums: How Intrinsic Value Protects Time Value

Meaningful option calculations are essential in determining if the premiums meet our goals. To this end, we must understand the mathematics of these calculations to become elite covered call writers. Now don’t worry…we don’t have to become Albert Einstein to be successful. But we do have to have a general understanding of the components of the option premium and how they influence our investment decisions.

Let’s start with the basic equation that many of you have seen in my books and DVDs:

Option premium = intrinsic value + time value

Intrinsic value applies only to in-the-money strikes and is the amount the strike price is below the current market value. As an example, if we bought Company BCI for $32 and sold the $30 call for $3, of that $3, $2 is intrinsic value (NOT profit) and $1 is time value (our true initial profit). Now, at-the-money and out-of-the-money strikes have premiums associated with them that are all time value since the strike price is not in-the-money. Examples:

  • At-the-money: Buy BCI for $30 and sell the $30 call
  • Out-of-the-money: Buy BCI for $28 and sell the $30 call

In this article, I will discuss and show hypothetical and real life examples of how intrinsic value protects time value when selling in-the-money strikes.

Hypothetical example

  • Buy BCI @ $32
  • Sell $30 call @ $3
  • Intrinsic value = $2
  • Time value = $1
  • Initial profit = $1/$32 – $2 = 3.3%

Since we only count $1 of the $3 premium as initial profit and we did, in fact, receive a total of $3, what happened to the other $2? We use it to “buy down” our cost basis from $32 to $30. This means we are guaranteed our 3.3%, 1-month return as long as share depreciation does not drop from $32 to below $30. I call this downside protection which is quite different from breakeven. It is protection of the initial profit. It is calculated as follows:

Downside protection = $2/$32 = 6.3%

I view the downside protection as an insurance policy which is paid for by the option buyer. When evaluating this trade, the calculations tell us the following:

We are guaranteed a 3.3%, 1-month return as long as share value does not decline by more than 6.3% by expiration. If that trade meets your goals then it’s time to make some money.

As an aside, to calculate breakeven we deduct the entire option premium from the initial cost:

$32 – $3 = $29

Real-life example: MYGN 

At the time I am writing this article, Myriad Genetics (MYGN) is a stock on our Premium Watch List and the options chain shows the following stats with 3-weeks remaining until expiration:

  • Price = $36.21
  • $35 strike = $2.30
  • Therefore, time value = $1.09 and intrinsic value = $1.21

Let’s allow the “multiple tab” of the Ellman Calculator (for a free copy, click on the “free resources” link at the top of this page) to do the work for us:

covered call writing calulations

Intrinsic value protects time value

The calculator shows that we are guaranteed a 3.1%, 3-week returns as long as share value does not decline by more than 3.3% by expiration. One of the many perks of being a covered call writer is that this “insurance policy” is paid for by the option buyer, not by us.

Summary

When using in-the-money strikes, the intrinsic value protects the time value or our initial profit. These strikes are most appropriate in bearish or volatile markets, when chart technicals are mixed and when the investor’s risk-tolerance is extremely conservative.

Next live seminar:

Arizona Point Options Group

Tuesday April 8th, 2014

7:15 – 9:15 PM

Rio Salado College Conference Center

2323 W. 14th St

Tempe, AZ 85281

 

Market tone:

Economic news this week was slightly positive despite to impact of harsh weather conditions. The Federal Reserve Board also had its first meeting with newly-appointed Chairwoman, Janet Yellen:

  • The Fed maintained to hold its stance on short-term interest rates @ 0% – 0.25% but moved away from tying the decision solely to inflation and unemployment (6.5% level). It will now use a “wide range” of factors in its policy-making decision of interest rates
  • The Fed acknowledged a slower housing recovery but improvement in the labor market, business investment and household spending
  • The Fed also announced that it would cut back its bond-buying program by $10 billion to $55 billion per month. This reflects confidence in the overall economy
  • New home construction dropped by 0.2% in February, more than projected but less severe than in December and January
  • Single-family starts rose by 0.3% whereas multi-family starts decreased by 1.2%, both improvements from December and January
  • Sales of previously-owned homes dipped by 0.4% in February slightly below forecasts
  • Year-to-year, housing starts are down by 6.4% whereas permits are up 6.9% and home c0mpletions are up 21.9%
  • Industrial production (a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) increased by 0.6% in February, driven mainly by a 0.8% rise in factory output. This doubled the stats expected by analysts. February’s total production is up 2.8% year-to-year
  • The Consumer Price Index (CPI), a measure of inflation) rose by 0.1% in February, below analysts’ predictions re-affirming that inflation is under control
  • Inflation is up 1.1% year-to-year
  • The Conference Board’s index of leading economic indicators ( a measure of economic outlook over the next 6 months) rose by 0.5%, better than the 0.4% projected by analysts
  • The coincident index (current economic activity) rose by 0.2% in February
  • The lagging index was up 0.3%

For the week, the S&P 500 was up 1.4% for a year-to-date return of 1.4%, including dividends.

 Summary:

 IBD: Uptrend under pressure

BCI: This site is cautiously bullish but because of geo-political events (Ukraine) and concerns regarding globalization (China), we continue to favor in-the-money strikes 3-to-2.

My best to all,

Alan (alan@thebluecollarinvestor.com

www.thebluecollarinvestor.com

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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.

8 Responses to “Option Premiums: How Intrinsic Value Protects Time Value”

  1. Barry B March 22, 2014 6:04 pm #

    Premium Members,

    The Weekly Report for 03-21-14 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  2. Adrian March 24, 2014 2:23 am #

    Hi Alan, I am back from my break and have found some more questions to ask for using the running list, and they are:-
    1. Are you willing to buy a share off running list if everything seems good about it and price trending higher,- but happens to be under a resistance level?
    2. When choosing between stocks with mixed technical indicators, are you more likely to be in favour of buying the one with the ‘MACD up’ but ‘Slow Stochastics down’, rather than the other way around, – or no difference to your choice?
    3. If I am wanting to buy a share off the ‘mixed indicators’ list, then is it best to wait for all the indicators to be positive before buying, or can I buy straight away and sell ITM options?
    4. Also if the beta says ‘n/a’ you had told me to check the ATM option return, but if the price is halfway between strike prices(or not quite close to one of them), then do I calculate to closest strike price anyway,- or wait until price moves closer?

    I’m starting to really enjoy the subscription to the premium reports, and articles from my last few months now. Thanks

    • Alan Ellman March 24, 2014 4:35 pm #

      Adrian,

      Glad you’re enjoying the process. My reponses:

      1- If trend is up and technicals are showing positive upward momentum, I have no problem taking on a 30-d obligation.

      2- With mixed technicals I am more likely to select an in-the-money strike whether its MACD histogram or stochastic oscillator showing a bearish signal. In a bull market environment, I overlook mixed technicals in many cases and still favor out-of-the-money strikes.

      3- Sell ITM strikes and take full advantage of time value before “theta” rears its ugly head.

      4- Run calculations on near-the-money strikes but don’t pull the trigger until the calculations meet your goals. Move on to another security if need be. Beta is a secondary factor…implied volatility is more important.

      Alan

  3. Adrian March 25, 2014 1:14 am #

    Alan, thanks for your replies here, and I was a bit surprised on that you would buy near a resistance level. I have observed a few stocks on the recent report that look to be at a resistance level, and am wondering if on my papertrades I should wait a few days for a possible breakout, or use a pullback for entry.

    1. So my 1st question, if you have no problem to buying near resistance areas, then does this mean you wouldn’t always be looking for a break above some pivot high, channel high, or even a previous days high before buying?(I thought this may be a better entry)?

    My next questions I have are about positioning strikes, and then rolling them.
    2. Would you if possible, try and position your strike prices around the support/resistance levels, like for instance just above a support level as price goes down(for a rolldown),etc?
    3. If the chart is mixed at expiration I know it’s best to roll-out the strike price, but would you still consider rolling out if the price is below the moving averages (or just one of them), yet the other indicators are positive?
    4. And when rolling down the strike prices, then how do I decide on if my rolldown I do should be ITM, ATM, or OTM,- what do you think are the reasons for making the best decision here?

    Alright well I’ll get back to selecting some stocks to try. Thanks for all your help.

    • Alan Ellman March 26, 2014 12:44 pm #

      Adrian,

      My responses:

      1- I handle my technical analysis differently for a 4-week cc position than I do a longer term strategy. I also encourage our members to use the technicals they are comfortable with but I’m happy to share the ones that I use and how I use them. If a stock is uptrending, trading above it’s 20-d EMA with bullish MACD and stochastic oscillator indicators and confirmed by volume, I have no issue entering a 30-d position with that security. I will, in fact, use bullish OTM strikes if the overall market is also bullish. When using stocks trending up but with mixed confirming indicators I will favor ITM strikes unless the market is red hot in which case I will still take a bullish OTM position.

      2- I base my strike price selection on 3 factors:

      – the 4 technical indicators mentioned above
      – overall market assessment based mainly of review of the weekly economic reports
      – personal risk tolerance

      3- This would be an unusual chart pattern with a stock dropping below its EMA but confirming indicators bullish. If this were to arise, I would probably allow assignment and move to another security the following week after expiration…less risk.

      4- Rolling down is used to mitigate losses or turn losses into gains. I normally roll down to an ATM (near the money) strike. If share value continues to decline, you can always roll down again or close the entire position and move the cash into another security. I check the news on the stock (finviz.com) and compare depreciation to overall market performance. I take a more bearish stance if the stock is significantly underperforming the overall market (go further ITM or sell the stock).

      Alan

  4. Phil March 25, 2014 7:17 am #

    Alan,

    I believe a particular Stock Price is going to decrease in the next Month. I’ve been looking at STO Call for a 1-Month ITM Option and want to make sure I understand the outcome.

    • Purchase Price = $46.00 ($46.00 x 100 shares = $4600.00)
    • Strike Price = $44.00
    • Option Premium = $3.30 ($3.30 x 100 shares = $330.00)

    Entering the information into the Multiple Tab of the Elite Calculator, it indicates the following:

    • Intrinsic Value = $2.00
    • ROO = 3.0%
    • Downside Protection = 4.3%

    Based on my calculations, I get the following:

    • My initial Cost = -$4600.00
    • Option Premium I receive = $330.00

    If the Stock Price stays above my Strike Price at Expiration, I must sell my Stock at $44.00. Assume at Expiration, the Stock Price was $44.01, thus called away. The financial result would be:

    • Initial Cost = -$4600.00
    • Option Premium = $330.00
    • Settlement Sum = $4401.00
    • Net Profit = $131.00 (-$4600.00 + $330.00 + $4401.00 = $131.00)

    Are my calculations correct? An alternative would be to apply an Exit Strategy prior to Expiration.

    Thank you for your time and effort regarding my question.

    Phil

    • Alan Ellman March 25, 2014 7:29 am #

      Phil,

      Your math is excellent with one minor correction.

      The initial (and final in this case) return is the time value of the option premium sold:

      $3.30 = IV ($2) + TV ($1.30)…TV is $1.30 = 3% for 1-month.
      We use the IV of $2 to “buy down” our cost basis from $46 to $44.

      After expiration, although share price is $44.01, we collect $44 because of our option obligation to sell @ $44.

      After expiration, you have $4400 per contract to establish new cc positions the following month. You also have the choice to roll the option prior to 4PM ET on expiration Friday.

      (Profit is $130, not $131)

      Alan

  5. Adrian March 27, 2014 5:03 am #

    Thanks again for all your replies, for my 3rd question I probably should have asked also if alright to roll-out a stock if the price above the 20dEMA but not trending higher, but instead channelling s/ways, with mixed MACD, etc indicators? (This happened with 1 of my papertrades but I decided just to rollout.)

    Anyway your answers have given me a bit more clarity to know that even if price is under a resistance area, that as long as I find all chart technicals positive then it seems alright to buy shares and put on a trade.
    More questions to come soon. Thank you

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