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 options 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 books and DVDs:
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 (excluding quarterly contracts of some exchange-traded funds) 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 frames until Expiration Friday, the greater the chance that the options 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. Here is a chart that depicts such time erosion:
2-Volatility– This is the fluctuation, not direction, of a stock’s 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 affect the time value of our option positions are time until expiation and volatility. I mention the other two only in the interest of completeness.
– 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.
– Share price increase…..Call value increases
– Share price decrease…..Call value decreases
How to use this information:
The intrinsic value of the premium applies only to I-T-M strikes. I view it as the insurance policy the option buyer purchases FOR US. The best environment to take advantage of intrinsic value is in a mildly bearish or volatile market and when stock technicals are mixed.
When time value reflects a potentially volatile situation, we must assess market conditions and equity technicals to determine if that security will be part of our portfolio and if so, which strike to sell. Premiums with high time value (5-8%, 1-month returns for at-the-money strikes) will appear more appealing in bullish markets and when stock technicals are positive.
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.
This week’s economic reports re-enforced this site’s moderately bullish outlook for modest growth:
- The Fed stated that it expects the unemployment rate to fall between 8.2% and 8.5% this year, a more bullish outlook than it had in November
- The Fed projects economic growth between 2.2% and 2.7% this year, slightlty less than previously thought
- The Fed predicts inflation to remain between 1.5% and 1.8% this year, below its target rate of 2%
- The Fed announced that it would keep short-term interest rate near zero through late 2014, an extension of a previous projection
- The Conference Board’s measure of future economic activity increased by 0.4% in December, higher than November’s 0.2% rise giving reason for cautious optimism
- GDP for the 4th quarter rose to an annualized 2.8%, the strongest performance since the 2nd quarter, 2010
- For the year, the US economy grew by 1.7%, down from 3% in 2010. This had a lot to do with debt issues in Europe, disasters in Japan and our bickering Congress
- Durable goods orders rose by a better-than-expected 3% in December, the 5th increase in the last 6 months
- New home sales fell 7.3% in 2011, a record low BUT 4th quarter sales rose an annualized 20% from the previous quarter and 3% higher than the same quarter in 2010
For the week, the S&P 500 increased by 0.1% for a year-to-date return of 4.8%, including dividends.
In this election year we are and will be hearing doom and gloom scenarios regarding our economy. Politicians (both sides) will do and say anything to get a vote. This site evaluates market tone based on weekly economic reports, the status of the CBOE Volatility Index (VIX) and technical assessment of the overall market (S&P 500). We are aware that catastrophic events (hurricanes, war etc.) can negate the trends but we do all we can to maximize our returns and meet our goals. Creating fear is effective in compiling votes but ineffective in creating successful investment outcomes. When a politician speaks about our economy, I become the little boy who is being chastised by his mother: I put one finger in each ear and break out a chorus of “la-la-la-la-la”.
This week I decided to take a broad look at the market since the sub-prime debacle and recession of 2008 to present day. I also present a graph of US GDP in that same time frame. The green fields represent the severe drop in the market in 2008 and the negative GDP and the yellow fields represent what has taken place since. Our economy is far from fully recovered. Unemployment, although improving, is far too high and the housing market must strengthen for a return to full economic recovery. When we risk our hard-earned money it’s important that we make our market evaluations based on the facts rather than on self-serving diatribes of others. We report, you decide: