Meaningful option calculations are essential in determining if the premiums meet our goals. To this end, we must understand the mathematics of these calculations to become elite covered call writers. Now don’t worry…we don’t have to become Albert Einstein to be successful. But we do have to have a general understanding of the components of the option premium and how they influence our investment decisions.
Let’s start with the basic equation that many of you have seen in my books and DVDs:
Option premium = intrinsic value + time value
Intrinsic value applies only to in-the-money strikes and is the amount the strike price is below the current market value. As an example, if we bought Company BCI for $32 and sold the $30 call for $3, of that $3, $2 is intrinsic value (NOT profit) and $1 is time value (our true initial profit). Now, at-the-money and out-of-the-money strikes have premiums associated with them that are all time value since the strike price is not in-the-money. Examples:
- At-the-money: Buy BCI for $30 and sell the $30 call
- Out-of-the-money: Buy BCI for $28 and sell the $30 call
- Buy BCI @ $32
- Sell $30 call @ $3
- Intrinsic value = $2
- Time value = $1
- Initial profit = $1/$32 – $2 = 3.3%
Since we only count $1 of the $3 premium as initial profit and we did, in fact, receive a total of $3, what happened to the other $2? We use it to “buy down” our cost basis from $32 to $30. This means we are guaranteed our 3.3%, 1-month return as long as share depreciation does not drop from $32 to below $30. I call this downside protection which is quite different from breakeven. It is protection of the initial profit. It is calculated as follows:
Downside protection = $2/$32 = 6.3%
I view the downside protection as an insurance policy which is paid for by the option buyer. When evaluating this trade, the calculations tell us the following:
We are guaranteed a 3.3%, 1-month return as long as share value does not decline by more than 6.3% by expiration. If that trade meets your goals then it’s time to make some money.
As an aside, to calculate breakeven we deduct the entire option premium from the initial cost:
$32 – $3 = $29
Real-life example: MYGN
- Price = $36.21
- $35 strike = $2.30
- Therefore, time value = $1.09 and intrinsic value = $1.21
Let’s allow the “multiple tab” of the Ellman Calculator (for a free copy, click on the “free resources” link at the top of this page) to do the work for us:
The calculator shows that we are guaranteed a 3.1%, 3-week returns as long as share value does not decline by more than 3.3% by expiration. One of the many perks of being a covered call writer is that this “insurance policy” is paid for by the option buyer, not by us.
When using in-the-money strikes, the intrinsic value protects the time value or our initial profit. These strikes are most appropriate in bearish or volatile markets, when chart technicals are mixed and when the investor’s risk-tolerance is extremely conservative.
Next live seminar:
Tuesday April 8th, 2014
7:15 – 9:15 PM
Rio Salado College Conference Center
2323 W. 14th St
Tempe, AZ 85281
Economic news this week was slightly positive despite to impact of harsh weather conditions. The Federal Reserve Board also had its first meeting with newly-appointed Chairwoman, Janet Yellen:
- The Fed maintained to hold its stance on short-term interest rates @ 0% – 0.25% but moved away from tying the decision solely to inflation and unemployment (6.5% level). It will now use a “wide range” of factors in its policy-making decision of interest rates
- The Fed acknowledged a slower housing recovery but improvement in the labor market, business investment and household spending
- The Fed also announced that it would cut back its bond-buying program by $10 billion to $55 billion per month. This reflects confidence in the overall economy
- New home construction dropped by 0.2% in February, more than projected but less severe than in December and January
- Single-family starts rose by 0.3% whereas multi-family starts decreased by 1.2%, both improvements from December and January
- Sales of previously-owned homes dipped by 0.4% in February slightly below forecasts
- Year-to-year, housing starts are down by 6.4% whereas permits are up 6.9% and home c0mpletions are up 21.9%
- Industrial production (a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) increased by 0.6% in February, driven mainly by a 0.8% rise in factory output. This doubled the stats expected by analysts. February’s total production is up 2.8% year-to-year
- The Consumer Price Index (CPI), a measure of inflation) rose by 0.1% in February, below analysts’ predictions re-affirming that inflation is under control
- Inflation is up 1.1% year-to-year
- The Conference Board’s index of leading economic indicators ( a measure of economic outlook over the next 6 months) rose by 0.5%, better than the 0.4% projected by analysts
- The coincident index (current economic activity) rose by 0.2% in February
- The lagging index was up 0.3%
For the week, the S&P 500 was up 1.4% for a year-to-date return of 1.4%, including dividends.
IBD: Uptrend under pressure
BCI: This site is cautiously bullish but because of geo-political events (Ukraine) and concerns regarding globalization (China), we continue to favor in-the-money strikes 3-to-2.
My best to all,
Alan ([email protected]