When studying option trading basics, a critical formula is:
Option premium = intrinsic value + time value (or extrinsic value)
This past week I hosted a seminar in New York and there were many inquiries regarding the difference between intrinsic and extrinsic value so I felt a blog article would be appropriate.
There are three types of strike prices as they relate to the stock price:
- At-the-money (ATM)
- In-the-money (ITM)
- Out-of-the-money (OTM)
The ATM strike is when the strike price and current market value are the same. An example would be when you buy a stock for $50 and sell the $50 call option.
The ITM strike is when the strike price is less than the current market value of the stock. An example would be when you buy a stock for $56 and sell the $50 call option.
The OTM strike is when the strike price is higher than the current market value of the stock. An example would be when you buy a stock for $48 and sell the $50 call option.
Of these three types of strike prices only the ITM strike has intrinsic or inherent value. In the example above, if we sold the $50 call when the stock was trading @ $56, the option buyer could exercise that option, buy it from us @ $50 and sell it at market for $56 generating a $6 profit. In this case the intrinsic or inherent value is $6. The ATM and OTM strikes have no intrinsic value so those options consist only of time value or extrinsic value. Let me give some examples:
ATM: Buy a stock for $50 and sell the $50 call for $1.50. The premium is ALL time value (our initial profit) and represents a 3% initial return ($1.50/$50).
ITM: Buy a stock for $56 and sell the $50 call for $8. The premium breakdown is as follows:
Option premium ($8) = Intrinsic value ($6) + time value ($2)
Our initial profit is NOT $8 because we will be losing $6 on the sale of the shares. Therefore, when calculating our initial profit for an ITM strike, we deduct the intrinsic value from the premium and the resulting time value is our real initial profit, in this case $2.
OTM: Buy a stock for $48 and sell the $50 call for $1.20. The premium is ALL time value as in the ATM example. In this case, $1.20 represents a 2.5% initial return ($1.20/$48).
***Do not include intrinsic value when calculating your initial option returns. For those of you who have access to the Ellman Calculator, these calculations will be automatically done for you after entering the information from the options chain.
Pros and cons of each strike type:
ATM:
- Generates the highest initial option return
- No upside potential from share appreciation
- No downside protection of the option profit (time value)
ITM:
- Generates a lower initial return than ATM strikes
- No upside potential from share appreciation
- Provides protection of the option initial profit from the current market value down to the strike price ($6 of protection from the above ITM example)
OTM:
- Generates a lower initial option return than the ATM strike
- No downside protection of the option initial profit
- Does provide upside potential for share appreciation from the current market value up to the strike price sold ($2 per share in the above OTM example.
I use ATM and OTM strikes when I am bullish about the stock and overall market conditions. I favor ITM strikes when I’m bearish about the overall market or when the technicals of the stock are mixed. Strikes can be “laddered” in most market conditions where you select a mix of strike types. The mix can be an equal number of each or favoring one type depending on market assessment and your personal risk-tolerance. More conservative investors will favor ITM strikes.
Real life example: ASNA:
Let’s take a look at the options chain (June contracts) for a stock currently on our Premium Watch List:
ASNA-options chain
Note the following: ITM $20 strike generates $1.55 (yellow) ATM (near the money) $21 strike generates $0.95 (green) OTM $22 strike generates $0.55 (purple) *These are all per share stats. Multiply by 100 to get per contract stats. Next we feed this information into the single or multiple tabs of The Ellman Calculator (blue cells) and the results are shown below:
ASNA- Ellman Calculator
Note the following:
- The $20, ITM strike generates an initial 3.5% return with 4.1% protection OF THAT PROFIT (yellow)
- The $21 ATM (near-the-money) strike generates the highest initial return of 4.6% but very little upside and no downside protection of that profit (green)
- The $22 OTM strike generates a 2.6% initial return with another 5.5% upside potential if the share appreciates higher. This represents a potential 8.1%, 5-week return (purple)
Conclusion:
Option premium consists of intrinsic value (ITM strikes only) + time (extrinsic) value. Only the time value represents our initial profit. Understanding the pros and cons of each strike type and basing our selections on chart technicals as well as overall market assessment will allow us to raise our profit returns to the highest possible levels.
Market tone: Here are this week’s reports:
- The trade deficit increased by $6.4 billion due to higher imports; exports held steady
- Consumer credit rose $21.4 billion in March twice analysts expectations
- The Producer Price index (PPI) dropped by 0.2% in April, the largest decline since 10/2011 mainly due to a decrease in energy prices
- Initial jobless claims for the week ending May 5th was 367,000, slightly less than the 370,000 the analysts were expecting
For the week, the S&P 500 declined by 1.1%, for a year-to-date return of 8.4%, including dividends.
Summary:
IBD: Market in correction
BCI: Cautiously bullish on our economy, concerned about global issues impacting our markets, and selling predominantly in-the-money strikes.
My best to all,Alan (alan@thebluecollarinvestor.com) www.thebluecollarinvestor.com
Re-Post from last night…
BCI Community,
It is with great pleasure that I am proud to announce that Alan Ellman has reached another level in his distinguished career. He has just become a grandfather. Please join me in welcoming Seneca Wade Ellman, weighing 7 lbs, 1oz., to the world. All of the Ellmans…Mom, Dad, Seneca, Alan, and Linda are doing great.
Respectfully,
Barry Bergman
Indirect Reply to you, Barry, and directly to Alan –
You came thru it well, indeed. We are all proud of you. (Please do not mind the jocular intent here) (Grin). To the new Grandfather and the new Grandmother, from a recent first timer at being a set of Great Grandparents.
Don B and wife Nancy B
Don, Nancy and all who have sent best wishes,
It doesn’t get any better than this! All you grandparents can relate, I’m sure.
The Ellman family
Premium Members,
The Weekly Report for 05-11-12 has been uploaded to the Premium Member website and is available for download.
Best,
Barry and The BCI Team
Alan,
Congratulations to you and your family. Please post a picture.
If I may a question about today’s article. Do you view the ATM or OTM strike more bullish?
Thanks for all this great information and my best wishes to your growing family.
Amy
Hi Amy,
Thank you!
I consider OTM strikes a more bullish position for two reasons. First, you are generating a lower initial options return and depending on share appreciation to make up for and surpass the ATM premium. Secondly, the breakeven is at a higher price point than with the ATM strike. That being said, in bull markets with great chart technicals I’m all over the OTM strikes.
Okay, you “twisted” my arm to include a picture of Seneca Wade Ellman:
Offsite Q&A that I thought would be of interest to many of our members:
QUESTION:
If the price of a stock goes over the call strike and is now in the money – will the stock be called away immediately or at expiration.
From what I have found out now it most probably gets called out at expiration – then what is the difference between an American and European style call – because I learned that an American style call can be exercised anytime, while a European style call can only be exercised at expiration. Then if they are American style calls why are they being only called away at expiration?
MY RESPONSE:
If an option gets exercised it will ALMOST always occur the Saturday after expiration Friday. An exception would be if there is a dividend distribution prior to expiration Friday and even that doesn’t guarantee early exercise. The reason options are generally NOT exercised early relates to the time value remaining in the premium. An in-the-money strike has intrinsic value + time value. Let’s say a stock is trading @ $66 and the $60 call is trading @ $7 ($6 IV and $1 TV). The option holder can exercise, buy @ $60 and sell @ $66 generating a $6 profit. However, why not just sell the option for $7? Whenever there is time value remaining on the premium it rarely pays to exercise early.
Alan
Another offsite Q&A:
QUESTION:
What if the call is in the money but not beyond our break-even – for example we bought a stock at $15 and sold the $16 call for a premium of $1 – what if the stock is at $15.50 – so it is beyond the strike price of $15 but still under the break-even of $16 – can it still be called away? I have read that in such a situation if the buyer of the call really needs the stock and is willing to lose the amount under the break-even the stock can be called away – though this would be to our benefit as we would still be in a profit – please advise.
MY RESPONSE:
An option holder will not exercise a $16 call if the price of the stock is $15.50. If the stock can be purchased at market for $15.50 why buy it from us for $16? The option buyer could care less what we paid for the underlying. He only looks at it from his own perspective and exercising @ $16 will create an immediate loss of $0.50 per share…not happening! BTW: Our breakeven is $14; the option buyer’s breakeven is $1.
Alan
One more Q&A:
QUESTION:
What if the stock goes above the strike and above the break-even and then retreats back much, much lower than the stock purchase price – for example we bought a stock at $15 and sold the $16 call for a premium of $1 – the stock goes to $17 but then a few days later retreats down to $13 – will the stock be called away? This actually happened to me and now I am in a position where the premium has dropped by 90% and so I can buy the calls back and sell new ones – but if I did that and later at expiration my stock is called away then my new short calls would be naked – please advise.
MY RESPONSE:
If you sold a $15 call and the stock is trading @ $13, the shares will NOT be called away for the same reasons I gave in the previous Q&A. When you buy back the calls and sell new ones, you now have only the obligation generated from the new calls. If those new calls were exercised, you will no longer have a short call obligation and will NOT be in a naked options position.
Alan
Alan,
That’s a nice photo of the baby above – so congratulations on being the grandfather for her!
From my last weeks questions on charts, I now wanted to ask some about using the indicators on them, and they are:-
– Do I need to use all my same chosen indicators on the S&P500, the Industry(possibly), and each of my shares – or just for my shares?
– And when using technical indicators then do you think that I need to know all the different type of signals that they give, to predict the potential price moves or reversals? (eg. for slow stochastics, along with the signals mentioned in the book there are also:- hinges, extremes, reverse divergences,etc,etc..)? thanks for your help.
Adrian,
Thanks for the “congrats”.
Put 100 technicians in a room and you’ll get 100 different responses as to which parameters to use and how to prioritize them.
I take a broader look at the overall market than individual equities. For the overall market I look at a 6-month chart of the S&P 500 to identify trend and market direction. I also analzye the VIX in the same time frame. Finally,l I look at each week’s economic reports to get a feel for the short-term health of our economy.
For stocks, I take a closer look using 20-d and 100-d exponential moving averages to identify short and longer term trend. I use MACD histogram and the stochastic oscillator to identify short-term momentum and volume to confirm or to identify divergences.
These are the parameters that I am comfortable with and that have worked well for me over many years of investing. I encourage you to check these indicators out but not necessarily limit yourself to them. Ultimately you will settle on the parameters that work best for Adrian without over-analyzing.
Alan
Congrats, GranPa
Feels great! Thank you.
Running list stocks in the news: RMD:
On April 26th, RMD (medical equipment for respiratory disorders) reported earnings that beat estimates by 12%. Revenues increased to $349 million from $310 million a year ago. Our premium “running list” shows an industry segment rank of “B”,a beta of 1.04 and a projected next ER date of 8-4-12. Analysts have been increasing earnings estimates as shown in the chart below.
Alan
To all members:
We have added a covered call glossary to the website. Look for the link on the top bar. See the screenshot below (click on image to enlarge and use the back arrow to return to this blog).
Alan
Running list stocks in the news: TCBI:
On April 25th TCBI (banking products and services) beat earnings estimates by 13%. EPS growth was 126% year over year with growth projection @ 10%. Our premium “running list” shows an industry segment rank of “A”, a beta of 1.49 and a projected ER date of 7/20/2012.
Alan
Running list stocks in the news: MNST:
On May 9th, MNST (alternative beverages) beat earnings estimates by 7.9% with revenues up 28%. Projected earnings estimates for 2012 increased by 9.7% and by 12% for 2013. MNSTnow has an implied growth rate of 22% for 2012 and 2013. Our premium “running list” shows an industry segment rank of “B”, a beta of 0.95 and a projected next earnings report date of 8-4-12.
Alan
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
Not a premium member? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
Running list stocks in the news: VSI:
On May 8th VSI (Vitamin Shoppe, Inc.) reported its 4th consecutive positive earnings surprise averaging a positive surprise of 13% over that time frame. Revenues increased by 14.4%. Our premium “running list” shows an industry segment rank of “A”, a beta of 1.09, and a projected next ER date of 7-28-12. Analysts have been jumping onboard for this stock as projected earnings growth has been on the rise as shown in the chart below. Click on image to enlarge and use the back arrow to return to this blog.
Alan
Facebook:
There is a little-known FINRA rule implemented in September, 2011 that prohibits brokers who are handling the public-market debut of IPOs from accepting “market orders” at the opening of public offerings. Retail investors (that’s us folks) must set “limit orders” at the open. This protects consumers from a scenario that transpired with Zillow which was priced @ $20, skyrocketed to $60 and then fell to $45 seconds later. Therefore, market orders at the open will be rejected. Once Facebook begins trading across all 13 US stock exchanges and private platforms, market orders will be fair game but we must all be extremely cautious of such orders. (I am not recommending this stock, just passing on new information).
Alan
Alan, I know you don’t usually discuss break even points as part of your calculations but if one did, is it correct that the breakeven point is always:
a) the stock purchase price minus the credit or
b) the strike price minus the time value
and these “formulas” are independent of whether the strike price is ITM, ATM or OTM?
Steve
Steve,
Your breakeven is the price paid for the stock minus the option premium generated of any strike type (ITM, ATM or OTM) . Formula (a) is always accurate.
Your second formula (b) applies to ATM and ITM strikes but NOT OTM strikes. For example, if you buy a stock for $28 and sell the $30 call for $2, the breakeven is $26, not $28 ($30 – $2).
Alan
Of course! Thanks for helping me keep my thinking straight!