Mastering the concepts of the time value of our option premiums and how theta impacts our option profits will help elevate our returns to the highest possible levels. Let’s first define these terms:
Definitions
Time value: The portion of the option premium that is attributable to the amount of time remaining until expiration. It is the amount above any intrinsic value (amount the strike price is in-the-money).
Theta: An estimate of how much the theoretical value of an option will decline with the passage of 1 calendar day.
As option sellers, we capture the entire premium once the trade is executed. The option buyers now own a decaying asset that is losing time value every day. Once again, the cash generated from the sale of the call options we sell is in our account and the amount we capture cannot be diminished. Another point to remember is that the initial profits generated from the sale of the call options is measured in time value only, not intrinsic value if we sold an in-the-money strike. So, if we bought a stock for $32 and sold the $30 call for $3, of that $3, $2 is intrinsic value (NOT profit) and $1 is time value, our initial profit.
Since our motivation is to generate monthly cash flow in a low-risk fashion, let’s focus in on maximizing time value by avoiding the impact of theta. One of the characteristics we need to be aware of is that time value erosion (theta) is logarithmic in nature NOT linear especially for near-the-money strikes. This means that the time value component of our option premium starts to erode slowly at first and then more rapidly as we approach expiration Friday as shown below:
Theta: time value erosion of our option premiums
Taking advantage of theta
Sell the options early in the 1-month contract: By doing this we will be avoiding the impact of the logarithmic nature of the time value erosion of our options which start declining in value slowly but then “falls off a cliff” later in the contract.
Weeklys vs. monthlys: There are pros and cons to both but from the perspective of time value and theta let’s view the 1-week and 4-week options chains for HAL captured in the first trading week of August, 2014:
HAL: 1-week options chain
HAL: 4-week options chain
If time value were linear (straight line) then we would expect the option value of the 1-week options to be 25% the value of the 4-week option values but that is not the case:
$70.50 call: $0.11/$1.04 = 10.6%
$71 call: $0.08/$0.87 = 9.2%
Now there are exceptions to these general rules when the market is anticipating a more volatile movement in share price in the near-term due to some upcoming event. However, understanding how theta impacts time value in most cases is an important concept to master in order to achieve the highest possible covered call writing returns.
Conclusion
Understanding the concept of how theta impacts the time value of our option premiums teaches us to enter 1-month contracts early in the contract and explains one of the advantages of monthlys over weeklys (there are pros and cons to weeklys but that’s a topic for another day).
Next live seminar: Coral Springs, Florida:
I will be in SE Florida for 11 days in early September attending to family real estate business and was invited to speak at a local options club which meets 15 minutes from where I’m staying. Here is the contact information:
South Florida Options Trading Forum
Thursday September 11th 6-9PM
http://www.meetup.com/options-fl/events/198999922/
Market tone:
A strong week of economic data was overshadowed by a weak jobs report:
- According to the Labor Department, 142,000 jobs were added in August well below the 220,00 expected. Despite this, the 3-month moving average of increases remains above 200,000, a favorable statistic for continued growth
- The unemployment rate ticked down from 6.2% in July to 6.1% in August due to a drop in the participation rate
- The nonfarm productivity rose by 2.3% in the 2nd quarter, much improved over the 4.5% decline in the 1st quarter
- Manufacturing productivity was up 3.3% in the 2nd quarter
- The US trade deficit declined to $40.5 billion in July, the lowest level since January. A reading of $42.2 billion was expected
- According to the Federal Reserve’s Beige Book the US economy exhibited broad economic expansion for the period from July to mid-August
- According to the Institute of Supply Management (ISM) manufacturing in August expanded at the fastest rate since February, 2011 to 59.0 from 57.1 in July (over 50 means expansion)
- The ISM non-manufacturing index came in at 59.6, up from 58.7 in July, the 5th positive movement in the past 6 months and now at its highest level since January, 2008
- Orders for US factory goods increased by 10.5% in July, the largest 1-month rise since 1992
- Construction spending rose by 1.8% in July, much better than the 1.0% anticipated
For the week, the S&P 500 rose by 0.2%, for a year-to-date return of 10%, including dividends.
Summary
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since August 15, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 3-to-1
My best to one and all,
Alan ([email protected])
www.thebluecollarinvestor.com
Hello Alan,
When writing covered calls on ETFs do you use the exact same exit strategies as with stock positions? Or do you make any amendments?
The question comes up as the expected returns are lower with ETFs so you might want to interfere earlier to protect your positions.
Thanks for your help.
David (from Hungary)
David,
Excellent question! We do use the same criteria because we are using percentages. Since the returns on ETFs are generally lower, a 10% or 20% call-to-action will be at a lower amount than for individual equities. For example, had we sold an ETF call for $1, we would buy back the option @ $0.20 or less in the first half of the countrat, a drop of $0.80.
Had we sold a stock call @ $2, we would buy back the option @ $0.40 or less in the first half of the contract, a drop of $1.60. Because we are using percentiles, we are accounting for the lower returns generated by ETFs.
Alan
Premium Members:
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 09/05/14.
For your convenience, here is the link to login to the premium site:
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Best,
Barry and the BCI Team
Alan,
On the topic of the greeks I have a question about delta. What is meant by being “long or short a certain number of deltas” I understand what delta is but not in terms of long and short.
thank you.
Barbara
Barbara,
As you know, delta represents the rate of change of an option price for every $1 change in the price of the underlying security. If BCI was trading @ $50 and the $50 call was priced @ $2 and had a delta of 0.5, we would expect a $1 price change to $51 to result in an option value of $2.50. A price change to $49 would result in an option value of $1.50 based on a delta of 0.50.
If a trader bought 4 contracts with a delta of 0.50, he would be “long 200 deltas” (0.50 x 100 x 4). If that same trader had sold 4 contracts, he would be “short 200 deltas” Since delta is an options equivalent of a stock position, it is the same as being long or short 200 shares of the underlying.
Alan
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Alan and the BCI team