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THE FACTORS THAT DETERMINE THE VALUE OF YOUR OPTION PREMIUM plus Our Readers Pick their Favorite Stocks

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 book, Cashing in on Covered Calls:

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 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 frame until Expiration Friday, the greater the chance that the option 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.

2-Volatility– This is the fluctuation, not direction, of a stock 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 effect 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.

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.

Last week’s economic news….not good!

1- Inflation increases: The Consumer Price Index (CPI) and The Producer Price index (PPI) both rose at a historically high annual rate in June. Higher energy costs including double-digit percentage increases in gasoline prices was mainly responsible for the rise in CPI. The PPI for finished goods which tracks inflation on a wholesale level, showed the largest 12-month increase in the last 27 years.

2- Retail sales increases .1% in June, far below analysts’ expectations despite billions of dollars of recession-fighting stimulous checks issued by Uncle Sam. A major factor in this arena was the 3.3% decline in auto sales.

3- An apparent plus in our economy was the jump in housing starts by 9.1% from their May level. However, this was false advertising since this figure was inflated by the rush to begin construction of multi-family units in New York City before July 1st, when new building codes took effect.

The Stock Market can sure use some better news on our economy in order to start heading back up again. Our economy has proven to be resilient time and time again. Why should I think any differently now? At the present time, I am sticking to my strategy of selling predominently in-the-money strikes of the greatest performing stocks in the greatest performing industries.

My Readers (and my wife Linda) Pick their Favorite Stocks:

Thanks so much to those of you who sent in your stocks picks the last few days. Even in such a challenging market you’ve managed to find several gems. I noticed that 7 of your selections were also on Linda’s list of stocks she gleaned from this week’s IBD 100. So I decided to publish these equities along with their associated scouter ratings:

WAB- 10

CMED- 8

BABY- 7

AMED- 10

AZZ- 8

APH- 10

AME- 10

Here is a list of Industries that have shown recent strength along with some of the best performers within those groups:

SCHOOLS (STRA, ESI, EDU)

TRUCKING (ODFL, JBHT, CNW)

DRUGS (NVS, CEPH, AZN, GSK,FRX)

MEDICAL EQUIPMENT (CMED, ILMN, BABY, MR)

Also note that the Gold and Silver Group which been strong the last few months, lost better than 4% last week.

One final word:

We are entering the height of earnings season. It is critical that you properly factor in Earnings Reports into your investment decisions. Please review DVD I of Advanced Seminar II of the DVD Series,  Advanced Seminar II of the Audio CD Series, and and pages 83 to 92 of the Companion Workbbook to properly prepare for the upcoming contract period.

Wishing you all much success,

Alan

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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.

19 Responses to “THE FACTORS THAT DETERMINE THE VALUE OF YOUR OPTION PREMIUM plus Our Readers Pick their Favorite Stocks”

  1. BOB BELTON July 20, 2008 8:41 pm #

    I noticed that it is not necessary to go toYahoo to get earnings dates. They are posted in the little charts on the IBD 100 list. I already have a position on AZZ and am waiting for the earnings dates on some of the others on my list BOB

  2. Alan July 21, 2008 3:55 am #

    Bob,

    Excellent observation. For those of you who don’t have access to my DVDs and CDs let me explain further:

    On the page opposite the IBD 100 list are the stock sharts. In the middle of MOST charts is a line that reads “EPS Due” with an associated date. This is the projected (but not guaranteed) date of the next ER. When adding a stock from that weeks IBD List, Bob is right on when he says that it is NOT necessary to go to another site for this information.

    However, when you are looking for an ER date for a stock already on your watchlist or of a security you located from another source, the best way to access the ER information is via one of the free websites I give you in The Cashing in on Covered Calls Products.

    Thanks to Bob for sharing this point.

    Alan

  3. admin July 21, 2008 4:36 am #

    EMAIL FROM 2 OF OUR EXPERIENCED INVESTORS:

    Hey, Alan! Keep up the great work. Here are some stocks we are looking at for selling AUG call options:

    AME – Electrical Equipment

    ARG – Chemicals-Specialty

    FLIR – Electrical-Military Systems

    GDI – Machinery-Gen Industrial

    RBN – Machinery-Gen Industrial

    WAB – Transportation-Equip Mfg

    Note that some of these have earnings coming out between now and July 24 so we are watching and waiting.

    All the best,

    Dave and Alex

  4. admin July 21, 2008 4:46 am #

    EMAIL QUESTION:

    Alan,

    Quick question. I have 5 stocks with earnings reported between 7/24 and 7/31. Would you recommend selling all of them so I don’t hold them during the earnings release?

    Thanks.
    Dmitriy

    My response:

    I,too, own many stocks that will be reporting this contract period. Here is how I handle these situations:

    1- If I feel real positive about the stock AND IT’S ASSOCIATED INDUSTRY, I may choose to own it throught the ER, without selling the option. I’ve used this philosophy with Apple Computer over the last few years successfully.

    2- If the ER is early in the contract period, I may own it throught the ER, let a day or two go by, and then sell this months option thereby getting the best of both worlds.

    3- Most of the time, I don’t want to risk the volatility of an ER so I just sell the stock during the 1st week of the contract period and use the cash to buy another equity (not reporting) and sell the option on that one.

    Best of luck,
    Alan

  5. BOB BELTON July 21, 2008 12:03 pm #

    HI ALAN,
    I have been setting at my computer and a thought came to mind. I am going to do a virtual trad on Wabtec (WAB) one of the stocks on my list and also on your list. Earnings come out tomorrow. I am going to buy 100 at 53.30 and will place a stop loss at 52.80. If earnings are positive and the stock goes up I will profit and also the premium on a STO should also go up. The risk of a bad earnings report would be $50 and I would not be commited further than that. It is a lot less risk than a straddle which the stock must move a lot to even break even. If the stock zooms then I haven’t lost potential profit on waiting to see what happens before placing a covered call write. Is this logical? I thought I would try a couple of stocks on the day before earnings come out to see if it works.
    Bob

  6. Alan July 21, 2008 1:12 pm #

    Bob,

    Ironically, I just completed writing a seminar I will be hosting for Norwegian Cruise Lines in a few months and WAB was the stock I chose to highlight.

    You’ve certainly selected a great performing stock in a great performing industry…congratulations for that. Have you factored in the (remote) possibility of a horrific ER causing the price to gap down well below your stop loss of $52.80 thereby causing a greater loss than $50?

    In my view, there is no right or wrong regarding taking on more risk. Each investor has his or her own level of risk tolerance and need for capital preservation.

    As you know from my book and DVDs, I am not a big fan of incurring the risk of an ER. My next book addresses this issue in greater detail and I think you will be amazed at the results you can get by managing ERs in a conservative manner.

    I admire investors such as yourself who are always looking for new and different ideas and thank you for sharing them with us.

    Alan

  7. BOB BELTON July 21, 2008 4:05 pm #

    ALAN, On second thought since earnings come out before the market opens tomorrow morning I should have set a tighter stop at 53.05.

  8. BOB BELTON July 21, 2008 4:10 pm #

    ALAN, You are absolutely right. I did not think of that .Example today on AAPL, it really went down a lot. Bob

  9. Owen Sargent, CPA July 22, 2008 10:18 am #

    Be careful with stop loss orders. They are not an assurance that you will get out at that price.

    Example: Apple closed 07/21 at $166.50. It announced a poor outlook after 5:00PM. It opened on 07/22 at $149.00.

    A stop loss set at $163 would have been executed, but not at $163. It never hit $163. It didn’t even wave at it on the way by. The stop loss would have executed at $149. At 2:15PM the stock is back up around $155.

  10. admin July 22, 2008 1:29 pm #

    A STOCK WORTH WATCHING:

    One of the most active stocks in today’s trading was ICON (ticker symbol : ICLR),a global provider of outsourced development services to the pharmaceutical, biotechnology and medical device industries. It reported a great ER and announced a 2-for-1 stock split.

    I will oftentimes add a stock to my watchlist when it demonstrates strong fundamentals, good news, and has attracted institutional interest.

    Check it out and see what you think.

    Alan

  11. Owen Sargent, CPA July 23, 2008 8:23 am #

    Always be careful you have the right stock when doing research on a suggestion. Example: Iconix Brand has the stock symbol ICON (and it has options). It is NOT the same stock as ICON Pub Ltd with a symbol of ICLR. As a matter of fact the two charts are pretty much mirror images of each other (ICLR has been steadily climbing and ICON has been steadily declining.)

    There are numerous stories of people suddenly trading the heck out of stock because they got the wrong symbol when they heard a news story. ALWAYS be sure you have the right symbol when making a trade.

  12. Jay July 24, 2008 10:17 am #

    I checked out ICLR and found 2 drawbacks for my trading rules. It has had a huge rise in the past 3 yrs. Could be due for a pull back? Also it is thinly traded as I like to stick to stocks of at least 500K avg daily volume. Thinly traded stocks tend to have huge spreads b/w bid/ask coupled with low open interests this could easily eat up your sold premium if you have to buy back sold options. Just my own rules. No wrong or right answers

  13. admin July 24, 2008 10:44 am #

    Jay brings out an excellent point regarding trading volume. I set my criteria at a lower number (250k shares per day, see page 79 of my book, Cashing in on Covered Calls) and ICLR still does NOT meet that figure (it trades on average 158k per day). Avoiding equities with lower range trading volume is another form of risk reduction. Thanks to Jay for bringing out this important point.
    Alan

  14. BOB BELTON July 26, 2008 6:32 pm #

    I JUST FINISHED CHECKING OUT THE IBD 100 AND CHECKING THE EARNINGS DATES. THE EARINING S DATES THAT I MENTIONED BEFORE IN THE IBD CHARTS ARE NOT ACCURATE, THEY ARE OFTEN OFF BY A COUPLE OF DAYS. I CHECKED THEM OUT ON YAHOO TO GET THE CORRECT DATES.

  15. sandrar September 10, 2009 5:51 am #

    Hi! I was surfing and found your blog post… nice! I love your blog. :) Cheers! Sandra. R.

  16. admin September 10, 2009 6:32 am #

    Sandra,

    Welcome aboard. Good to have you.

    Alan

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