Mastering options trading basics includes understanding the factors that impact our option premiums. The original Black Scholes pricing model was designed to evaluate European Style options which can only be exercised on expiration Friday, not earlier. Here is a brief summary of the factors considered in these original pricing models:
Factors for original option pricing models
These four main factors have been detailed in my books, DVDs and many of my blog articles and videos. We must know and understand the concept of these pricing factors to become elite options traders. In today’s article I will discuss two additional factors that have been added to more recent option pricing models, interest rates and dividends. These factors apply more to American Style options, which can be exercised at any time from option purchase to 4PM ET on expiration Friday. The main significance interest rates and dividends have is on the possibility of early exercise of our American Style options.
Interest rates
As interest rates rise, the difference in the cost of a share of stock versus the cost of an option becomes more significant. A trader can buy an option instead of a stock and invest the unused cash to generate income from the higher interest rate. Therefore, the call buyer is willing to pay a higher price for the call option. Rising interest rates also make it more enticing to exercise a put early and use the cash generated from the sale of the underlying securities to benefit from the higher interest rates.
Dividends
Call buyers benefit from share appreciation and put buyers benefit from share depreciation. When a dividend is distributed (or more accurately, when the ex-dividend date approaches) the value of the underlying security drops in value by the amount of the dividend. This makes the value of the call option lower and the value of a put option higher as dividends rise. Early exercise of call premiums is more likely when the strike is in-the-money and the time value of the option premium is less than the dividend about to be distributed. Early exercise, when it occurs, usually takes place 1-2 days prior to the ex-dividend date.
Here is a summary of the minor factors found in the more recent option pricing models:
Factors included in recent option pricing models
Summary
There were four major factors included in the original option pricing models which were geared to European Style options. These were the stock price, the strike price, the expected volatility of the stock and the time to expiration. Newer pricing models now also include statistics for interest rates and dividends which apply to potential early exercise of American Style options.
Next live seminars
Phoenix, Arizona area:
1- Phoenix Point Options Group
January 9, 2015: Tempe, AZ: 7:00 – 9:00 PM
Link is above…scroll down.
2- American Association of Individual Investors- Phoenix Chapter
January 10, 2015: Scottsdale, AZ: 9 AM – 12PM and 1:15 PM to 2:30 PM
Market tone
We had a mixed week of economic reports with the most significant one being the most positive:
- According to the Commerce Department, GDP (inflation-adjusted value of all goods and services produced in the US) grew at an annualized rate of 5% in the 3rd quarter. Both consumer and business spending contributed to this strong number
- The GDP stats from the 2nd and 3rd quarters represented the 1st time since 2003 that the economy grew by an annual rate > 4% for 2 consecutive quarters
- Sales of existing homes declined by 6.1% in November, the first drop in the past 3 months
- Sales of new homes fell by 1.6% in November below economist’s projections and the 2nd straight monthly decline
- The median price for new homes dropped to $280,900 from $290,100 in October
- Personal income rose by 0.4% in November, the highest level since June, mainly due to wages and dividend growth
- Personal spending ticked up by 0.6% above the 0.5% expected
- Durable goods orders fell by 0.7% in November, the 3rd decline in 4 months
- Initial jobless claims for the week ending December 20th came in at 280,000, below the 290,000 anticipated
For the week, the S&P 500 increased by 0.9% for a year-to-date return of 15%, including dividends.
Summary
IBD: Uptrend under pressure
GMI: 6/6- Buy signal since market close of December 19, 2014
BCI: Cautiously bullish due to the weakened housing news, selling equal numbers of in-the-money and out-of-the-money strikes. Selling out-of-the-money puts is another way to navigate markets of concern.
Happy New Year to one and all. Together, let’s make 2015 a great financial success,
Alan (alan@thebluecollarinvestor.com)
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 12/26/14.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Alan,
I take just five minutes of your time to ask your opinion on an idea I had on ETF’s with low & medium volatility.
The idea is:
In an ‘up trend’ hold only the ETF.
In an ‘down trend’ write covered calls.
I checked the chart on BLV since inception, and the down trends were always short lived for my risk tolerance (we speak about Bonds ETF’s here), circa 5% on average, this year.
I think with a monthly dividend payment (3.8 % annually) which you reinvest immediately in shares purchases + the capital gains in an up trend + covered calls gains you reinvest in shares purchases in short lived down trends, this will work fine on ETF’s like BLV and will increase A LOT your monthly dividend payments over a few years.
What do you think ?
Cordially,
Marc from Luxembourg
Marc,
I always encourage our members to think outside the box and look for alternate ways to use this great strategy of covered call writing that will meet our particular trading style. In general terms, your idea is excellent and another way to manage a covered call portfolio. Here are some factors to consider:
1- Check the open interest and bid-ask spreads for BLV to make sure that it is a good candidate for buying and selling options.
2- Have the bull market aspects of the charts you have studied been such that a writer of calls is better off not selling options over the alternative of selling out-of-the-money calls where we may generate BOTH option premium and share appreciation?
3- Are we prepared and okay with early assignment? If an ex-dividend date occurs prior to contract expiration and the time value component of that premium is < the dividend about to be distributed, early assignment is possible. There are ways to manage around this but preparation for such exit strategy opportunities must be part of the game plan. Keep up the good work. Alan
Dear Alan.
In response on your questions
Yes, there is a problem with the open interest and bid-ask spreads for BLV
Here is how I manage them:
According the chart I sent to you, since last Friday (Point Pivot on Heikin-Ashi candlesticks with MACD confirmation) I got last Friday a ‘down trend signal’, so I sold an out of the money January $94.00 call for $0.44 (actually was sold Thursday).
23 December was the ex-dividend date (monthly dividend is $0.305), I was long (up-trend), and I pocket (I will be paid the 30 December) the dividend. Now, on this date I will buy more shares with the received dividends and this will lower my average, overall, purchase price.
Next ex-dividend date will be the 1 February (I guess) so I’m sure that the $0.44 from the January $94.00 call sale will go entirely in my pocket, as the January calls will expire the 19 January before the next ex-dividend date. On this date I will again buying more shares with the call gains, averaging again down, my overall purchase price for ‘BLV’.
That’s great……..
About 10 – 15 January (but perhaps, if the down trend continues, I will roll down in the same month my calls, to pocket more premiums, to buy more shares with the obtained money, to averaging again down my overall purchase price…..) I will roll to the next month (02/2015), never losing sight, that the call value MUST be over $0.30 (since the value of the call I write is always > the $0.305 dividend, I’m never bothered with early assignment).
On ‘BLV’, because of the lack of open interest, and the wide bid-ask spreads, I try to work exclusively with limit orders, and as explained, I sell only, next month’s calls to get more premium (next week, we will be in January, and if the down trend continue, I will roll the call to next available month, which will be in my case February). If my limit order is taken thru the day, its ok, if not I check the bid price. If this one is > the dividend’s value I change my order in a market order, if not I don’t write covered calls (as the down trend is on average only 5 % (in 2014) and short lived (a few days, max. 1 month), I can sit relax, to wait next up-trend, which will offset the max 5% loss (that’s the beauty with ‘BLV’….bond ETF).
In case I have an covered calls in my books, and the uptrend resume, I wait until the remaining TIME VALUE is < next dividend distribution value, and I TRY to buy the call back.
If for ‘X’ reasons I wasn’t able to buy back the call for MY price, I let my shares be assigned. This doesn’t bother me as I get capital appreciation (remember, I wrote an out of the money call).
I agree this strategy takes a little time. Will take, 15 – 20 minutes / day.
Sorry for my English (it’s not my mother language)
Marc G. from Luxemburg
Alan,
I don’t think the disposition of shares is accounted for in paper trading, so let me ask this.
What happens to my shares at end of contract in each scenario?? Kept or called away?
1.) Buy 100 shares of xyz for $50
sell to open $49 call
end of contract stock is $51
2.) Buy 100 shares of xyz for $50
sell to open $49 call
end of contract stock is $49
3.) Buy 100 shares of xyz for $50
sell to open $49 call
end of contract stock is $48
As you can see, all scenarios are ITM and very similar. Only difference is final stock price as compared to the option (above, at, below). Do I have the potential to have my shares called away if I take no action before the end of the contract?
Hope I kept the question simple yet gave enough info to allow for brief answers.
Best Regards,
Joe
Hi Joe,
If you take no action, shares will be sold if the closing price is $0.01 or more above the strike at expiration. Final resolution of closing prices may actually be calculated a few minutes after 4PM ET as later orders are processed so to avoid exercise, if the price is very close to the strike near 4PM, buy back the option:
1- Shares are sold at the strike price.
2- Shares may be sold at the strike price…no definitive answer for this one.
3- Shares are not sold, option expires worthless…we keep option premium and still own the shares.
Alan
Open interest:
We’ve had a few inquiries regarding the significance of open interest for options and why we include a column in our premium stock reports showing if OI for near-the-money strikes is adequate according to the BCI methodology (> 100 contracts or a bid-ask spread of $0.30 or less). The reason is that poor option liquidity (OI) usually results in unfavorable trade execution pricing because of the wider bid-ask spreads. As an example, RYAAY has passed the BCI screens but does not have adequate OI AT THIS TIME. In the screenshot below, we can see the wide b-a spread for the near-the-money $70 strike with the stock trading at $70.62.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO THIS BLOG:
Alan,
What is the best way to keep accurate records to prepare IRS form 8949?
Guy
Guy,
Before I respond I want to emphasize that any tax decision you make should be after consultation with your broker and tax advisor and not by anything I have to say in this response.
Since the IRS started asking for accurate cost basis and options reporting information about 2 years ago, tax advisors have been faced with a dilemma as to how to report. My understanding after speaking with several CPAs is that most reliable brokerages are reporting accurately. Many tax advisors simply attach the brokerage statement to the Schedule D or Form 8949. When filing electronically, there is another form that may be used (Form 8453).
If possible, trade in a sheltered account. If not, a good tax advisor should be able to manage the changing tax environment.
Alan
Hi Alan,
Of late, you have suggested half covered calls with strikes ITM and half with strikes OTM. After identifying your candidates of strong, high quality stocks, are there any specific steps you take in determining which securities you select to write ITM strikes vs OTM strikes ?
Larry
Larry,
There are two excellent ways of managing this issue:
1- If you are selling multiple contracts, split them as to strikes used: If 4 contracts, 2 ITM and 2 OTM.
2- Favor OTM strikes for securities with the strongest technicals and ITM strikes for those mixed or slightly weaker technicals…getting that “insurance policy” for the technically weaker (but still great cc writing candidates) stocks.
Alan
Premium members:
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
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Wishing all our members a happy, healthy and prosperous 2015.
Alan and the BCI team