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 book, Cashing in on Covered Calls:
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 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 frame until Expiration Friday, the greater the chance that the option 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.
2-Volatility– This is the fluctuation, not direction, of a stock 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.
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 effect the time value of our option positions are time until expiation and volatility. I mention the other two only in the interest of completeness.
– 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.
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.
Last week’s economic news….not good!
1- Inflation increases: The Consumer Price Index (CPI) and The Producer Price index (PPI) both rose at a historically high annual rate in June. Higher energy costs including double-digit percentage increases in gasoline prices was mainly responsible for the rise in CPI. The PPI for finished goods which tracks inflation on a wholesale level, showed the largest 12-month increase in the last 27 years.
2- Retail sales increases .1% in June, far below analysts’ expectations despite billions of dollars of recession-fighting stimulous checks issued by Uncle Sam. A major factor in this arena was the 3.3% decline in auto sales.
3- An apparent plus in our economy was the jump in housing starts by 9.1% from their May level. However, this was false advertising since this figure was inflated by the rush to begin construction of multi-family units in New York City before July 1st, when new building codes took effect.
The Stock Market can sure use some better news on our economy in order to start heading back up again. Our economy has proven to be resilient time and time again. Why should I think any differently now? At the present time, I am sticking to my strategy of selling predominently in-the-money strikes of the greatest performing stocks in the greatest performing industries.
My Readers (and my wife Linda) Pick their Favorite Stocks:
Thanks so much to those of you who sent in your stocks picks the last few days. Even in such a challenging market you’ve managed to find several gems. I noticed that 7 of your selections were also on Linda’s list of stocks she gleaned from this week’s IBD 100. So I decided to publish these equities along with their associated scouter ratings:
Here is a list of Industries that have shown recent strength along with some of the best performers within those groups:
SCHOOLS (STRA, ESI, EDU)
TRUCKING (ODFL, JBHT, CNW)
DRUGS (NVS, CEPH, AZN, GSK,FRX)
MEDICAL EQUIPMENT (CMED, ILMN, BABY, MR)
Also note that the Gold and Silver Group which been strong the last few months, lost better than 4% last week.
One final word:
We are entering the height of earnings season. It is critical that you properly factor in Earnings Reports into your investment decisions. Please review DVD I of Advanced Seminar II of the DVD Series, Advanced Seminar II of the Audio CD Series, and and pages 83 to 92 of the Companion Workbbook to properly prepare for the upcoming contract period.
Wishing you all much success,