The timing of our option trade executions will impact the success of our covered call writing returns. The BCI methodology prides itself on having rules and guidelines for buying back options, re-selling options and selling long stock positions. One question that many of us have thought about is when to enter our 1-month trades. My books and DVDs have guidelines for this as well:
- For a 4-week contract ( 8 of these per year), we enter the trade within the first few days of the contract
- For a 5-week contract (4 of these per year), we enter the trade within the first 7 trading days of the contract
The reason we don’t want to wait longer than these time frames is due to the impact of theta or time value erosion. Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one calendar (not trading) day while there is no change in stock price or volatility. For near-the-money strikes, theta is logarithmic in nature (not linear) and causes time value erosion to start off slowly and then impact our premiums more as expiration approaches as shown in the chart below:
With this in mind, many covered call writers intuitively feel that they should establish new positions on expiration Friday rather than the following Monday to capture some extra time value and negate the impact that theta will have over the weekend. To see if this approach will benefit us in most cases we must further investigate how traders value the options when using option pricing models. For every calendar day that passes, the option value will decline by the amount of the theta. To really dissect this in a blue collar manner we must ask ourselves when the calendar day is deducted from the pricing model…Friday…Saturday…Sunday…once each day?
It is fair to say that many traders assume the day is deducted and option premium value is decreased at the end of each calendar day and base their trades on that assumption. However, that frequently is not the case as traders anticipate the price decline and calculate option value prior to the end of a trading day or prior to the weekend. We may notice option values declining on the Thursday before expiration Friday and more so mid-day on expiration Friday as options are now being priced at Monday’s theta value. In other words, the weekend days are already deducted and so there may be no added value of entering trades on expiration Friday compared to the following Monday. In addition to this, we are now exposed to weekend risk for very little reward, if any at all.
Of course, there are many other factors that impact option value (the Greeks) so we can’t make a blanket statement that we are always better off waiting until Monday. However, we can say that based on the manner in which theta is factored into option value, waiting until the beginning of the week after expiration is generally a better way to enter new covered call trades.
The end of an era
Next live seminar
Philadelphia Chapter of The American Association of Individual Investors
September 30, 2014
Blue Bell, Pennsylvania
We had a mixed bag of economic reports this week, with an eye on geo-political events in Syria, Iraq, the Ukraine to name a few:
- According to the National Association of Realtors, sales of existing homes fell in August to an annualized 5.05 million after rising the 4 previous months. This represents a 1.8% decline from July but still the 2nd highest level in 2014
- According to the Commerce Department, new-home sales in August were up by 18% from July and 33% year-over-year
- Initial jobless claims for the week ending September 20th came in at 293,000, below the 300,000 expected by analysts
- According to the Commerce Department, durable goods orders in August fell by 18.2%, slightly worse than the decline of 17.9% anticipated. Excluding the transportation sector, there was actually a 0.7% rise in orders
- 2nd quarter GDP growth rate was revise upward to 4.6% from 4.2%. This was the best quarterly growth rate since the 4th quarter, 2011
For the week, the S&P 500 declined by 1.4%, for a year-to-date return of 9%, including dividends.
IBD: Uptrend under pressure
GMI: 2/6- Buy signal since market close 8/15/14
BCI: This site is still bullish on our economy but will tweak positions to half in-the-money and half out-of-the-money strikes as we keep an eye on the aforementioned geo-political events
Wishing you the best in investing,
Alan ([email protected])