Educated covered call writers know that it is critical to sell our options early in the 1-month cycle. I always try to sell my options in the first week of a 4-week expiration cycle and no later than the beginning of the second week of a 5-week cycle. The reason has to do with the time value of the option premium and the erosion of its value over time. This is known as theta and it is one of the option greeks..
Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one day while there is no change in the stock value or volatility. Theta is expressed as a negative number since the passage of time will decrease time value. If the time value of an option premium falls by $0.05 each day, its theta is said to be – 0.05. You will remember the equation for the value of an option:
Option Premium = Intrinsic Value + Time Value (extrinsic value)
Since intrinsic value only changes with the movement of the stock price, theta plays no role. However, it does have a major impact with time value and covered call writers should be aware of this relationship.
Theta’s role in reducing option value:
As an option approaches expiration Friday, theta has a greater impact on the option value. Let’s look at a 1-month graph of a hypothetical option value:
Notice how the decline in time value starts off gradual (red), accelerates (blue), and then “falls off a cliff” (green).
Theta and strike prices:
Since A-T-M strikes have the greatest time value (ROO), they have the most to lose over time. Therefore, theta is greatest for A-T-M strikes and lower as options go deeper I-T-M or O-T-M.
Theta and volatility:
As volatility decreases, theta increases and vice-versa.
Theta and days to expiration Friday:
Theta increases as there are fewer days to expiration Friday.
Theta and covered call writing:
It is important to understand the general concept that theta plays a major role in devaluing option premiums especially for our 1-month contracts. This favors our strategey in three ways:
1- Allows us to capture a generous option premium shortly before its dramatic time value decline.
2- Allows us to close our positions profitably during the week of expiration Friday if we chose to do so as the cost to B-T-C has dramatically declined especially if the stock price has not changed.
3- Allows us to execute a mid-contract exit strategy at a reduced price.
Understanding theta also drives us to selling our options at the ideal time, not too early and not too late.
It is not necessary to analyze the specific theta of our sold options however, understanding the principles of theta and the impact it has on our option values will make us better investors.
This week’s premium report (Weekly Stock Screen and Watch List) and list of top-performing ETFs has been uploaded to your premium site and are available for your inspection.
A nervous and volatile market will tend to overact and hence we get huge up and down price movements. This is not the friend of covered call writers. May’s unemployment stats disappointed despite the fact that unemplyment did decline. Manufacturing did expand and productivity gains does seem to foreshadow more job creations. The service sector also showed signs of growth for the first time in two years. Once again, market pyschology is controlling our stock market as fear is turning buyers into sellers.
I constructed both 3-month and 1-month comparison charts of the S&P 500 and the VIX. In an ideal market the S&P 500 would be uptrending while the VIX downtrending or stable at low levels. These charts show quite the opposite. In the 3-month chart below:
We see that the volatility has increased nearly 80% while the benchmark has decreased by 5%. In the more recent 1-month chart:
We see the VIX up a whopping 40% in the last month while the S&P has declined by nearly 10%.
IBD: Market in confirmed uptrend****updated to “uptrend under pressure”
BCI: Remain short-term bearish due to market volatility and longer term bullish. My cc portfolio currently has 50% broad market ETFs and 25% equities (no covered calls sold this month) and 25% cash which I will continue to dollar-cost average into the broad market ETFs. My plan is to sell calls for the July contracts as long as the market volatility subsides. It has two weeks to convince me!
Many thanks to our members for your astute and important blog commentary. It represents an incredible learning and sharing experience for all of us.
Alan ([email protected])