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Factors that Determine the Value of your Option Premium

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 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:

Time erosion of an option premium

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. More on this topic in a future article.

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.

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.

– 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) 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.

Market tone:

Another week of predominantly disappointing economic reports. The producer price index (PPI) for finished goods increased by 0.2% in July, housing starts rose 1.7% which was below expectations and unemployment claims rose to 500,000 higher than expected and the most since November. On a positive note industrial production rose 1.0% in July, better than anticipated and the Conference Board’s index of leading economic indicators increased by 0.1% in July. The total picture is that of a very slow and sluggish economic recovery. For the week the S&P 500 was down 0.7% for a year-to-date return of -2.7% (including dividends).

This week I have constructed a 3-month chart comparing the price action of the S&P 500 and the movement of the CBOE Volatility Index. In an ideal world we would like to see a slowly rising S&P 500 and a declining or stable VIX (under 30). Let’s look at the graph:

S&P 500 vs. The VIX as of 8-20-10

Note the following:

  • The S&P 500 has been relatively flat over the past 3 months (red circle), a neutral indicator.
  • Recently we see a downturn in market performance (red arrow), a bearish sign.
  • The VIX has been declining by over 40% in the past 3 months (green circle), a bullish signal.
  • The VIX has been on the rise lately (green arrow), a negative.

Summary:

IBD: Uptrend under pressure

BCI: Neutral, anticipating a sideways moving market and selling I-T-M strikes for protection against market volatility.

The best in investing to all,

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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32 Responses to “Factors that Determine the Value of your Option Premium”

  1. admin August 22, 2010 3:29 am #

    PREMIUM MEMBERS:

    This week’s list of top-performing ETFs has been uploaded to your premium site. There are several new candidates. These securities have been up in price between 10-17% over the past 3 months while the S&P 500 has been down by 2%. Look in the resource/download section for Top-Performing ETFs dated 8-19-10.

    Alan

  2. Brad August 22, 2010 4:46 pm #

    Alan,

    Do you tend to avoid at the money options because they offer no protection (no intrinsic value) and no chance of price appreciation?

    Thanks for a great system.

    Brad

  3. admin August 22, 2010 7:14 pm #

    Brad,

    Your assessment of A-T-M strikes is right on target in that it offers no protection of the option premium and no hope of additional income from share appreciation. HOWEVER, this is the strike that offers the HIGHEST initial option return so I DO NOT avoid them in all situations. I use A-T-M strikes in more bullish market conditions when stock technicals are favorable. Also, when selling multiple contracts per month, you can “ladder” (my term) your strikes having some O-T-M, some I-T-M and some A-T-M with the higherst percentage based on current market conditions.

    Alan

  4. admin August 22, 2010 8:33 pm #

    PREMIUM MEMBERS:

    This week’s Weekly Stock Screen and Watch List has been uploaded to your premium site.

    Alan

  5. admin August 23, 2010 1:35 pm #

    Premium Report Upgraded:

    Today we added a new feature to your premium report. We have added DIVIDEND YIELD information. For those equities that have earned their way onto our watch list that also offer dividends will now be highlighted on the watch list with current dividend yield information. This will represent another parameter you may choose to use to help enhance your bottom line results. The report that was uploaded to your premium site yesterday has been revised to reflect this additional information. For those who have printed out the most recent report may want to return to the premium site and print out the report that was uploaded today (Monday).

    My team and I will continue to work hard to provide our members with the best and most useful information to assist you as you make your Blue Collar decisions.

    Alan

  6. Don B August 23, 2010 2:01 pm #

    Hi Alan –

    SLW shows as being removed from Running List. This one was on it for five weeks. STO & MACD charts look good. 100 d & 20 d EMA seem politely below the price range. Stock Scouter shows a 5. No ER looms.

    How can I know which factor done the dirty deed?

    New dividend feature is NICE!

    Don B.

  7. Barry B August 23, 2010 3:04 pm #

    Don B (Post #6),

    The reason SLW is not on the list this week is that it failed the Smart Select screen.

    Barry

  8. admin August 23, 2010 4:55 pm #

    The following information has been updated on the most recent premium report:

    AKAM is scheduled to report earnings after market close on 10-27-10

    Alan

  9. Ed B August 23, 2010 5:03 pm #

    Since I have a high priority to preserve capital, I look first at downside protection when using the Elite Calculator. I use the Weekly Report to screen for stocks with a >2.0 % ROO, with >5.0% downside protection. This is hard to find in the current market environment. Most stocks with 5+% downside protection range generally between .5% – 1.5% ROO.

    In the BCI experience, is around a 1.5% ROO for deep ITM options (5 – 8% downside protection) reasonable? I know Alan’s criteria is 2 – 4% ROO, but most in that range are ATM or OTM.

    Any thoughts or observations appreciated.

    Ed

  10. DaveD August 23, 2010 5:25 pm #

    ED B

    Check out EJ…

    The last few months its been uptrending… It shows support around $13-$14..

    It we bought the stock now and sold the September 15 Call we would have 4.6% downside protection. This is close to the 5% your after.

    In addition our ROO is 2.2%…

    Dave

  11. Ed B August 23, 2010 5:45 pm #

    Dave – Thank you for the information. I will look at it furhter.

    Appreciate you taking the time on this question.

    Regards,
    Ed

  12. Don B August 23, 2010 8:03 pm #

    To Dave D:

    Somehow or other I cannot make your numbers (in #10) come together. First, did you mean the Sep14 call rather than the 15? Using the 14 I come up with a ROO of 2.6%. (.35/13.46). I acknowledge I have never quite understood the term “downside protection”.

    Don B

  13. Don B August 23, 2010 8:09 pm #

    Please just FORGET that I sent my number 12, above, out. Sorry, I see I just misread something somehow.

  14. admin August 23, 2010 8:40 pm #

    Downside protection:

    In the BCI system this is defined as the percentage a stock value can depreciate in value and still generate the original return on the option (time value). It applies only to I-T-M strikes and represents the intrinsic value of the option premium. Our system is predicated on generating a monthly cash flow by selling options. Downside protection is the leeway we have in protecting that entire amount. For example, if we sell a $50 call option for $3 on a stock trading at $51, $1 is intrinsic value and $2 is time value or our profit. Downside protection is $1/$51 or 2%. Our profit is $2/$50 = 4%. So our 4% profit is protected as long as our shares do not depreciate in value by more than 2%. This is different from the “breakeven” which would be the entire option premium. Here is a link to an article on this topic:

    https://www.thebluecollarinvestor.com/blog/selling-the-in-the-money-strike-a-new-way-of-thinking/

    Alan

  15. admin August 24, 2010 8:11 am #

    Ed (#9),

    Your approach is an extremely intelligent one given your level of risk tolerance. A few points to consider in this regard:

    1- The deeper I-T-M you go, the lower the option return (time value). You are trading higher returns for more protection which may be perfectly appropriate for you and many others.

    2 The deeper I-T-M you go, the higher the “delta” of the option premium. This means that for every $1 change in stock price, there will be a similar change in option value. This is helpful if the stock declines in value and we want to close out short option position as it will be cheaper to buy back the option.

    3- We are currently in a short options cycle- 4 weeks- which also includes a holiday. Time value is reduced because of this.

    Keep up the good work.

    Alan

  16. owen August 24, 2010 10:46 am #

    Re Ed B #9 – you have perfectly described the tradeoff between risk and reward. You reduce your risk using the ITM calls, and you reduce the return. However, the last line in your first paragraph is still not a bad return, that you will wind up with a return of .5% to 1.5%. That is per month. That still annualizes to 6% to 18%. I really can’t think of many other (legal) investments that will offer you that liquidity and that return.

    I agree completely with Alan in his #15 comment. You are balancing your income return with your capital preservation very wisely. Your approach is a terrific example that covered call writing can be as conservative, or agressive, as you feel comfortable with.

  17. Ed B August 24, 2010 11:18 am #

    Alan – Thank you for the clarifications and additional insights. My cautious approach may not be the same investing style as most. It is just what helps me sleep at night.

    Here is a recent example I had last month.

    On July 29 I bought DIG at $28.84. Technicals were decent at that time (in a range with slight trend up). Sold the Aug 27, which had a 6+% downside protection. During early Aug it actually went higher, to the point where I started to look at buying back the option to capture the net gain above the option premium. It did not make economic sense. Then during Aug, technicals broke down and it went down below cost and into the downside protection. By expiration Friday, it opened at 27.10. As I looked at noon it was 26.81. I decided to buy the option and sell the etf. I salvaged about 1% return for the 22 days. At the close, DIG ended the day at 27.16. I debated internally if I acted too soon. Since no one knows the future, I decided not to take the chance of possibly losing all the premium or being below breakeven.

    This is what makes the BCI system very powerful. You decide, you control the outcome. Most people cannot take the responsibility and think someone can do it better than you. For me, in 2003 I became a ‘do it yourselfer’. It has taken years to learn more than systems, terminology and styles. I have learned more about myself, controling emotion and treating this as a business.

    When I stumbled on your books, especially, Exit Strategies, a couple of months ago it was like unlocking a door.

    Thank you again for your help.

    Regards,
    Ed

  18. owen August 24, 2010 1:11 pm #

    Ed, magnificent example.

    Alan, congratulations. Now THAT is why your books and videos are so important. There are hundreds of books on how options are calculated, mystic trading strategies, Black-Scholes formula, but yours are the ones written for the Blue Collar Investors.

    Good job. Thank you.

  19. Ed B August 24, 2010 2:12 pm #

    Owen re #16 and #18

    Thank you for your responses. Your points are well taken. I will take the conservative covered call returns any day!

    To your point on the books and other educational material, I couldn’t agree more! I have many of those options books on my book shelf, but the ones I keep in my brief case for reference are Alan’s. They are written in a clear direct manor.

    Thank you Owen and Alan for your insights.

    Regards,
    Ed

  20. admin August 24, 2010 4:54 pm #

    I just placed an ice pack on my head as it is beginning to swell! Many thanks for the kind remarks. I am currently writing my third book and I’m hopeful that it will also earn your endorsement.

    Alan

  21. admin August 25, 2010 12:47 pm #

    FFIV:

    This is a great example of a stock that offers the entire range of strike selection possibilties. The I-T-M $80 and the O-T-M $90 offer a 2%, 1-month return with huge protection or upside potential. The A-T-M (near-the-money) $85 offers a great initial return on option but little protection and no upside. Feed the option chain info into the single tab of the Ellman Calculator to review the specific calculations. It’s an excellent exercise for strike price selection.

    Alan

  22. DaveD August 26, 2010 2:09 am #

    One of the GREATEST things about trading the US market is the fact that the market opens at 11.30 at night here in Australia… It closes at 6am in the morning…

    Its not uncommon for me to wake up at 5am, make a few clicks on my computer and earn some $$$ and then go back to bed with dollars in my pocket…

    Yes, its a hard days work!

    Dave

  23. admin August 26, 2010 11:41 am #

    Dave , BCI community,

    We are fortunate to have a large and growing international presence. We are all united in our common goal of achieving financial independence through education and sharing information. Thanks to one and all for your participation and invaluable blog contributions.

    Alan

  24. admin August 26, 2010 11:46 am #

    AGP:

    Another stock from our premium watch list recently has its third consecutive POSITIVE earnings surprise elevating its price near a multi-year high. The debt/equity ratio is at 22.5% below the industry average of 28.2%. Earnings estimates were also recently raised. AGP trades at a reasonable 11x forward earnings.

    Alan

  25. owen August 26, 2010 2:32 pm #

    I don’t know how investors will greet this story about Apple, but it seems they may announce a new line of Ipods next week. http://www.dailyfinance.com/story/company-news/apple-may-unveil-new-line-of-ipods-next-month/19608940/?icid=main%7Cmain%7Cdl8%7Csec3_lnk2%7C166260

  26. admin August 27, 2010 6:18 am #

    ETF Report:

    Premium members: This week’s report on the top-performing ETFs with options has been uploaded to your premium site. You will note that these securitites are dominated by international funds that have increased in value between 13% – 20% in the past three months while the S&P 500 has declined by 2.5%. Look in the “download/resource” section of the premium site for “Top-Performing ETFs” dated 8-26-10.

    Alan

  27. owen August 27, 2010 10:06 am #

    Hey, Dave, how about telling the government to let Paul Hogan go. Maybe he owes A$30 million in taxes, and maybe he doesn’t, but his Crocodile Dundee movies probably provided more Australian tourism than any of the “put another shrimp on the barbeh” commercials.

  28. admin August 27, 2010 3:10 pm #

    BCSI:

    I know a few of you held this stock through the last two ERs both of which have been rough. I was encouraged by the $2 share price increase over the past 5 days. The computer networking sector is in the top 7% of new institutional money flow. That’s also a positive along with improving technicals.

    I’m sure you are aware that it is expected to report again on November 19th but you may not know about the annual shareholders meeting scheduled for October 7th. Both of these events can impact the share price significantly in either direction.

    Alan

  29. DaveD August 28, 2010 4:23 am #

    Owen,

    Yeah Paul Hogan is all over the news here in Australia… Its crazy…

    Cant even leave Australia to be with his wife and son who reside in L.A…

    Thats a crazy amount (30million) to ask someone to pay up… Who do they think he is? Warren Buffett?

    Dave

  30. DaveD August 28, 2010 5:02 am #

    BCSI

    Yes, this stock has been set alight the last couple of days…

    Thanks for the update Alan

    Dave

  31. admin August 28, 2010 7:16 am #

    Many of us are faced with the dilemma of whether to buy back our option and “roll” our short position to the next month or allow assignment of our shares on or near expiration Friday. Recently I have had several inquiries about this topic. Check out my latest journal article to be published later this weekend which will discuss this subject PLUS a new feature has been added to our premium report.

    To get email notification of all my new publications, join my mailing list:

    https://www.thebluecollarinvestor.com/joinfrnds.shtml

    Alan

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