Analyzing The Time Value Of In-The-Money Strikes

Maximizing covered call writing profits requires us to master strike price selection. Very few covered call writers outside the BCI community use in-the-money strikes and, as a result, do not achieve the results that we do. Recently, a few BCI members sent me emails commenting how in-the-money strikes do not generate profits that meet their goals. These members were looking for significant downside protection with a 2-4%, 1-month return. In bearish or volatile markets I am absolutely on the same page with these astute investors with the caveat that the term significant needs to be defined.

The deeper in-the-money the strike is, the more protection we have but the lower the time value component of the premium will be. There is a tradeoff…more protection for less profit and vice-versa. To demonstrate how this works, I have selected PRLG a stock on our Premium Watch List (6/28/13). The stock is trading @ $65.83 so let’s view 3 in-the-money strikes

• $65
• $60
• $55

Below is the options chain at the time of this writing (7-2-13):

PRLB-Options chain

Looking at the bid columns we see the following covered call writing premiums:

• $65: $3.20 (yellow)
• $60: $6.60 (pink)
• $55: $10.90 (purple)

With 13 trading days remaining until expiration, let’s feed this information into the multiple tab of the Ellman Calculator:

PRLB & The Ellman Calculator

The following conclusions can be made from these calculations:

• The returns on the options (ROO) is inversely related to the amount of downside protection
• You will need to set your goals before determining which strike price is right for you
• The deeper in-the-money a strike moves, the time value of the premium will approach zero

Conclusion:

In-the-money strikes offer downside protection of the time value component (our profit) of the option premium. This is very different from the breakeven which is always the stock price minus the entire option premium generated from the option sale. The more downside protection we have the lower the profit will be. Once we set our goals for our monthly returns, we can easily determine which strike price is most appropriate for our portfolios. However, as the strike moves deeper in-the-money and the time value approaches zero, there will be some strikes that should not be used for covered call writing because they generate little or no time value as is the case for the $55 call for PRLG.

What is a mark?

One of our members sent me an email using this term that I hadn’t heard mentioned in years so I thought I’d post in this week’s blog:

Mark is the mid point between the bid and the ask.

Market tone:

A strong jobs report with a mix of other economic reports confirmed the bullish economic outlook of this site:

• According to the Labor Department, non-farm payrolls increased by 195,000 well above the 166,000 expected. April and May payrolls were also revised higher
• The unemployment rate remained unchanged @ 7.6% as additional new hires were offset by more people entering the workforce. A strong housing market and a boost in service employment were critical to these statistics
• The first 6 months of 2013 has shown an average jobs growth of about 200,000/month, the level required to result in a drop in the unemployment rate
• Factory orders (a key measure of industrial-product demand. The report’s formal name is Manufacturers’ Shipments, Inventories and Orders, not to be confused with the Census Bureau’s report on business inventories) rose by 2,1% in May, slightly above expectations
• Construction spending in May rose by 0.5% primarily due to a rise in multi-family residential construction
• The trade deficit widened in May to $45 billion ($40.8 billion anticipated) due to slower demand in Europe and China and rising demand by US consumers. This has been interpreted as a positive sign for our economy
• The ISM non-manufacturing index fell to 52.2 in June below the 54 expected but still showing expansion
• The ISM manufacturing index moved slightly above 50 to 50.9

For the week, the S&P 500 rose by 1.6% for a year-to-date return of 16%, including dividends.

Summary:

IBD: Market in correction.

BCI: Moderately bullish currently slightly favoring in-the-money strikes for the short-term. This was a positive week for the markets but volume was low because of the holiday.

Wishing all our members an enjoyable and safe holiday,

Alan ([email protected])

www.thebluecollarinvestor.com