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Theta-Time Decay of our Option Premiums

Educated covered call writers know that it is critical to sell our options early in the 1-month cycle. I always try to sell my options in the first week of a 4-week expiration cycle and no later than the beginning of the second week of a 5-week cycle. The reason has to do with the time value of the option premium and the erosion of its value over time. This is known as theta and it is one of the option greeks..

Definition:

Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one day while there is no change in the stock value or volatility. Theta is expressed as a negative number since the passage of time will decrease time value. If the time value of an option premium falls by $0.05 each day, its theta is said to be – 0.05. You will remember the equation for the value of an option:

Option Premium = Intrinsic Value + Time Value (extrinsic value)

Since intrinsic value only changes with the movement of the stock price, theta plays no role. However, it does have a major impact with time value and covered call writers should be aware of this relationship.

Theta’s role in reducing option value:

As an option approaches expiration Friday, theta has a greater impact on the option value. Let’s look at a 1-month graph of a hypothetical option value:

Theta- 1-month Chart

Notice how the decline in time value starts off gradual (red), accelerates (blue), and then “falls off a cliff” (green).

Theta and strike prices:

Since A-T-M strikes have the greatest time value (ROO), they have the most to lose over time. Therefore, theta is greatest for A-T-M strikes and lower as options go deeper I-T-M or O-T-M.

Theta and volatility:

As volatility decreases, theta increases and vice-versa.

Theta and days to expiration Friday:

Theta increases as there are fewer days to expiration Friday.

Theta and covered call writing:

It is important to understand the general concept that theta plays a major role in devaluing option premiums especially for our 1-month contracts. This favors our strategey in three ways:

1- Allows us to capture a generous option premium shortly before its dramatic time value decline.

2- Allows us to close our positions profitably during the week of expiration Friday if we chose to do so as the cost to B-T-C has dramatically declined especially if the stock price has not changed.

3- Allows us to execute a mid-contract exit strategy at a reduced price.

Understanding theta also drives us to selling our options at the ideal time, not too early and not too late.

Conclusion:

It is not necessary to analyze the specific theta of our sold options however, understanding the principles of theta and the impact it has on our option values will make us better investors.

PREMIUM MEMBERS:

This week’s premium report (Weekly Stock Screen and Watch List) and list of top-performing ETFs has been uploaded to your premium site and are available for your inspection.

Market tone:

A nervous and volatile market will tend to overact and hence we get huge up and down price movements. This is not the friend of covered call writers. May’s unemployment stats disappointed despite the fact that unemplyment did decline. Manufacturing did expand and productivity gains does seem to foreshadow more job creations. The service sector also showed signs of growth for the first time in two years. Once again, market pyschology is controlling our stock market as fear is turning buyers into sellers.

I constructed both 3-month and 1-month comparison charts of the S&P 500 and the VIX. In an ideal market the S&P 500 would be uptrending while the VIX downtrending or stable at low levels. These charts show quite the opposite. In the 3-month chart below:

3-month comparison chart

We see that the volatility has increased nearly 80% while the benchmark has decreased by 5%. In the more recent 1-month chart:

1-month comparison chart

We see the VIX up a whopping 40% in the last month while the S&P has declined by nearly 10%.

Summary:

IBD: Market in confirmed uptrend****updated to “uptrend under pressure”

BCI: Remain short-term bearish due to market volatility and longer term bullish. My cc portfolio currently has 50% broad market ETFs and 25% equities (no covered calls sold this month) and 25% cash which I will continue to dollar-cost average into the broad market ETFs.  My plan is to sell calls for the July contracts as long as the market volatility subsides. It has two weeks to convince me!

Many thanks to our members for your astute and important blog commentary. It represents an incredible learning and sharing experience for all of us.

My best,

Alan (alan@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.

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25 Responses to “Theta-Time Decay of our Option Premiums”

  1. admin June 6, 2010 8:14 am #

    Premium Members:

    This week’s report on top-performing ETFs was revised today to include full name, sector and recent price information.

    Alan

  2. John from Napa June 6, 2010 1:47 pm #

    Hello Allan. What is the reason for switching your account more into ETF’s going forward, rather than more cash? We know that ETFs provide less cc income generation that individual equities because of less implied volatility( risk), and more diversification ( less risk also). But if you are conservatively setting up your portfolio going forward for anticipated large market swings, and a potential larger drop (as many pundits are predicting will come), why not just hold more cash for a few months and really play it safe? If you would, what is your reason to continue to purchase ETF’s ( stocks) at this point of market instability with such a large risk of more decline as a 50/50 real posibility?

  3. Doug June 6, 2010 2:06 pm #

    Hi Alan,

    Theta

    One Greek per week would be an interesting approach to all those numbers. I now understand better what theta means. But I’m not sure how it’s useful (I don’t know how to profit from any other greek either). For example, if I have two choices to make that are equal in every other regard for the next month, would one having a different theta than the other make it a better choice?

    Market

    You’re one day late with IBDs outlook. After Friday’s heavy decline, the IBD outlook changed to “Uptrend Under Pressure”. At the moment, this perhaps subtle looking distinction is significant. No uptrend starts without the type of follow through day IBD called early last week, but many follow through days get reversed and nullified, especially if followed soon after by a distribution day, such as we had on Friday. A look at the daily chart shows the dow sinking very close to the bottom of the current “uptrend”, and with heavy volume. If that momentum carries just a bit further, and we break below the previous low, then you’ll hear IBD switch us back to full correction mode just as quickly.

    Long winded, but the message to readers is that IBD is far from yelling “All clear to buy!”.

    – Doug

  4. admin June 6, 2010 3:41 pm #

    John,

    In most markets, I find the “pundits” in disagreement with each other. Turn on CNBC any day and market experts will be both bullish and bearish. Perhaps they set up their guests that way to present both perspectives but there is rarely universal agreement. As a result, I try to come to my own conclusions based on my personal risk tolerance and experiences. Which group has the best perspective is yet to be determined and nobody can be 100% certain no matter how loud they scream.

    My feeling is that the market fundamentals are still in place for an improving stock market. Remember, too, that as cc writers, we only need the market to trend sideways to have favorable conditions for our strategy. That being said, we have been enduring extreme volatility the last few weeks and this is an enemy of cc writers. That is why I went into a predominantly cash position several weeks ago. My view is that concerns over Europe’s financial problems have placed our markets in the hands of market pyschology rather than fundamentals. I believe that corporations will be showing better bottom line results and therefore improving prices once volatilty subsides. So the question of the day is when will that transpire?

    Those who feel that this will take many months or that there is greater than a 50/50 chance of more declines should stay in cash, I agree.

    Those (like me) who feel that this could happen sooner and may want to take advantage of a recovering market in a conservative manner may want to take the route I described in my article. Once the volatiltiy subsides, I plan to exchange the ETFs for individual equities and sell calls on stock, not ETFs. By dollar-cost averaging into ETFs I am simply participating in a market in a conservative manner that I believe will be recovering. I am open to changing my mind if parameters should change but this is my approach and judgment at this time. As always, let me reiterate that there is no cut and dry, right or wrong here, just one man’s opinion and decision. I respect those who disagree or may choose to take a different approach. We can all learn from each other.

    Alan

  5. admin June 6, 2010 4:00 pm #

    Doug,

    Thanks for that IBD update. I added this info to the article.

    I agree with you that knowing the specific numbers associated with the Greeks is not helpful to the average cc writer. However many of the associated concepts are important to understand (like the graph I showed of the the time decay of a 1-month option). I have found that over the years, the more information I acquire, the more confident and successful an investor I become. Some of this information is highly relevant, some less so. For me, understanding the Greek stats is not critical for us but understanding the concepts associated with them is useful and that is why I framed my conclusion as I did.

    One more word about these articles, a little inside information if you will. I take credit (or blame) for many of the topics addressed on this blog. But many are the result of inquiries and suggestions made by our readers. As it happens, discussion of the Greeks has been one of the more highly requested subjects and a subject that ALWAYS comes up in my seminars. I appreciate your comment as it gave me the opportunity to explain this to the BCI community.

    Alan

  6. Doug June 6, 2010 4:10 pm #

    Thanks Alan. The more insight the better, even if occasionally abstract. So keep the education coming.

  7. John from Napa June 7, 2010 12:25 am #

    Thanks Allan fo the view on ETF’s. As I mentioned once in a previous email, it does appear the pundits are themslves about half right and half wrong–it is a rule I call Board’s ( short for Boardeaux, my Canadian name) 50/50 axiom: You can always find a smart knowledgable person out their with very logical backup data for thier opinions for both sides of any question. So at 50/50 odds–you have to pick a side based on what moves you for your own assumptions to act on.

    I personally went to about 75% cash about 3 weeks ago and dumped just short of 100 dividend stocks to practice only the BCI strategy going forward ( and for once got the timing right). I am going to sit and watch for awhile but still have my toe in the water a little. I think I am comfortable playing it even more conservatively than you are at this point in time.

    Thanks for these blogs–we are all learning allot continually–it is like being in a classroom.

  8. Doug June 7, 2010 8:28 am #

    I agree, of course, that selling 1 month options is great in that one captures the time decay as it drops most precipitously.

    However, where I have a problem, and am unsure how to remedy it, is that as we get closer to expiration, since the calls we sold have very little time value remaining (whether that be the last day, the last week, etc.) we are basically in the same position as if we simply held the stock.

    In other words, assuming we are not deep in the money at that point, we have no downside protection and almost nothing to gain by our covered calls. There’s nothing I hate more than watching a stock go down by $1 in the last week when I only had .10 in time value to collect.

    It is because of this that I have been wondering if it might be worthwhile to sell more time and actually get out a couple weeks before expiration. Is there any sense to this? If not, what other alternatives do we have?

    Doug

  9. admin June 7, 2010 12:38 pm #

    Doug,

    There is a lot of sense to your comment. If the time value is $0.10 as in your hypothetical and share price is near the strike so there is no advantage of staying in your position, an exit strategy does make sense. You will note that in my books and DVDs, I title exit strategies in the latter part of the contract as “on or near” expiration Friday. There is no guideline in place to make you hold your position if it doesn’t make sense.

    Premium members who have access to the (nearly completed, I promise) Elite Calculator, can use the “unwind now” tab to calculate your results if you unwind at any point in time. This is exactly why we developed this tab for the calculator.

    If the market value is well above the strike, unwinding and using the cash for another position that month probably will not be benficial as there is little or no time value remaining and the stock price is well above the strike so protection is in place.

    But your point is well taken. In your scenario where the time value is negligible and the share price is near the strike with no protection, cashing out may be the best approach.

    Alan

  10. admin June 8, 2010 1:52 pm #

    GIS:

    I noticed this stock was trading on high volume today and also up in price. It has strong fundamentals and a nice uptrending chart pattern. Look for us to add it to the premium watch list if these factors hold through the week.

    Alan

  11. admin June 8, 2010 2:08 pm #

    Flash Trading-1000 point drop:

    Interesting article by Dick Grasso, former head of the NYSE:

    http://www.nypost.com/p/news/business/why_we_need_human_touch_yL5zpPlq15m9sPkmTliOSN?sms_ss=email

    Alan

  12. admin June 9, 2010 8:08 am #

    I received an off-site question from Bill that I felt would be of interest to other members of our BCI community. He asked about the best time frame to use when setting up price charts for technical analysis.

    Since technical analysis is as much an art as it is a science different chartists will have different preferences. Here are mine:

    I like using DAILY prices shown by OHLC bars (candlesticks are excellent as well) with time frames of between 6 months and 1 year. Stockcharts.com defaults to a 6-month time frame which can be lengthened or shortened. This 6-12 month time frame is long enough to identify a trend (up or down) or lack thereof (sideways). It also gives recent historical data where, for example, you can determine how the stock reacted the last time it dipped below the 20-d ema. The 6-month default is more than adequate; the 1-year may give a little more historical data but the most recent 6-months is more significant than the first 6 months.

    Alan

  13. admin June 9, 2010 7:55 pm #

    GIS:

    I’ve received a few off-site emails regarding the unusual price decline of this stock since I highlighted it yesterday. It actually wasn’t a decline but rather a 2-for-1 stock split. This halves the price of the stock and doubles the number of shares owned so the total capitalization remains the same.

    Alan

  14. Rob June 10, 2010 4:16 pm #

    Alan and all,

    I bought nflx in April after the earning report. I sold the option in April for May but I’m just holding it for June because of the market volatility. This one keeps going up and I’m getting a little nervous about a drop. I see it’s on the premium list for 10 weeks but how long can this last!

    Not complaining,
    Rob

  15. admin June 11, 2010 4:35 am #

    Rob,

    Some investors will set a 5-8% stop loss if you can’t monitor your position closely or take some cash off the table and sell some shares. It has been on quite a run after the profit-taking post ER.

    Alan

  16. admin June 11, 2010 4:48 am #

    Market volatility and charts:

    Many price charts are mixed due to the current market volatility with only few having all-confirming parameters. For example, check out SWKS….neutral at best but great fundamentally and meets our system criteria. If we were to sell the July $15 call, we could generate a near 4%, 5-week return with downside protection (of this premium) of 5%. Although I am not selling calls this month, I continue to keep an eye out for potential candidates as I am hoping to get back in for the July contracts. Premium members should look at stocks located in the “white areas” of the running list and favor those with the highest industry segment rankings. You will note that both NFLX and SWKS have rankings of “A”.

    Alan

  17. admin June 11, 2010 11:45 am #

    Premium Members:

    This weeks list of top-performing ETFs with options has been uploaded to your premium site. Look for ETF Top Performers dated 6-11-10 in the resource/download section.

    Alan

  18. Amy June 12, 2010 2:10 pm #

    Rob,

    I just looked at this weeks IBD 100 list and see NFLX is rated #1.

    Good pick.

    Amy

  19. admin June 12, 2010 2:18 pm #

    Radio interview:

    Cuurently playing a radio interview I did a few months ago:

    http://www.TheBusinessAuthorsShow.com

    Alan

  20. DaveD June 12, 2010 4:44 pm #

    TSL

    Ths stocks fundementals are not in place…

    But its technical picture shows a stock thats seriously on the rebound with a postive MACD and stochastic. The price bars are showing a classic double bottom of a $15 support line…

    Will the market allow this stock to venture out of the abyss though?

  21. Barry B June 12, 2010 4:56 pm #

    DaveD,

    Be careful with TSL. The solar industry is still, heavily subsidized. a major market for solar has been in Europe. With the austerity measures that are beginning to arise there, make sure that you check out where (geographically) TSL gets its’ business from. I recall reading a few weeks back that a number of European countries will be cutting their to solar power installations.

    More homework always helps.

    Barry

  22. Don B June 12, 2010 6:12 pm #

    Hello All –

    On BCSI – I have gritted my teeth (not a strategy) and hoped ( also not a strategy) and have held on.

    Could find NO bad news on it. MSN Scouter Rating comes in at a cheerful 8! Their single negative seems to be a somewhat higher PE ratio. A 2-year chart shows they have had their 100 day, 20 day, and price inverted in the past similar to now and have come out of it well. Comments, anyone? Thanx.

    Don B.

  23. Marc B June 12, 2010 11:39 pm #

    Barry is spot on with the solar issue. With the EU headwinds, solar is not very attractive. While it may return a short term bounce, the medium term outlook for the industry is just not that great, and there are better spots.

  24. DaveD June 13, 2010 1:20 am #

    Hi Don

    On BCSI, the techncal picture shows the stochastic and MACD about to turn positive. The ADX is showing exhaustion which means the downward trend has maybe come to an end.

    In addition, from the Analyst Recommendations: there are 7 saying buy, 8 saying hold and 0 are saying sell.

    Although the smartselect ratings are showng abit of a rabble, the EPS of 98 is still a positive.

    Personally, im holding onto my BCSI shares. Im selling calls 1 strike above the current price (25.00)…

    For the month of July, we can currently get 0.45c. If you bought the stock at around $34 thats 1.3% for the month. Now its not a great deal of cashflow. But, here is some positives to look at.

    1) Thats 15.6% annualised.
    2) That alone outperforms the market avarage.
    3) If you had this money in the bank you would recieve only 4-5% interest per annum.
    4) The stock will likely go back. When it does go up you can just roll up and either sell at a profit, breakeven or at a smaller loss than what it is now.

    Good Luck Don

    Dave

  25. Marc B June 13, 2010 11:28 am #

    On BCSI – the p/e is near 23 which is not bad, but not an outstanding value in this market. The issue is to recover to $34 will push the p/e into the 30’s.

    I think keeping it or not depends on a number of issues.

    1. What % of your portfolio is BCSI. For me if it was a substantial portion, I would get out and put my money where it could earn over double what you can earn on BCSI without praying/hoping for a miraculous 50% recovery.

    2. Would you buy it now if you didn’t own it? I wouldn’t. Higher PE than some and much higher if it gets back to $34. Small ROO of around 1.3%. Once again better options out in the market.

    3. I agree that the technicals are poised for a turnaround, but I have seen technicals poised for months.

    4. What is your market outlook? If it is bullish overall, then there are better spots for your capital. If bearish, and you plan to stay largely in cash, then keeping it may be a better alternative to cash, if you strongly believe all the downside is out.

    Giving up on a loser is difficult for all of us. The correct play is not always apparent. Although I only sell calls after the stock has been put to me (I am a put seller), I will only stay in the stock if it meets all of the citeria I put forth in the earlier points. I liken it to a falling elevator. If you are on an elevator heading to the 35th floor, and at the 34th floor the elevator suddenly starts to fall, but stops at the 22nd floor. After a few hours the doors open, an elevator mechanic tells you all is fixed, and any minute now the elevator will be heading back up. Are you going to stay on that elevator? Not me! I am going to find the stairwell. Yes it is much harder to walk up the steps, but I know I can get back to the 35th floor with a much higher degree of safety and success.

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