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Option Basics – Option Premium

The premium is the price paid or received for an option.  Options are traded much like stocks with the bid and ask prices as shown:

  • Seller receives the bid price;
  • Buyer receives the ask price;
  • The marker marker keeps the spread between bid and ask prices.

The premium refers to the total amount received for selling the option contract not the option price.  The premium means the option’s contract price on a per share basis.  For example, if the option contract price is shown as $1.25, this means you receive $1.25 per share or $125.00 per contract ($1.25 * 100 shares).  

The premium can be intrinsic and time value.  Intrinsic value is the portion of premium that is in-the-money.   Time value is the portion of premium that is not in-the-money which is also known as “extrinsic value.”  Time value is the amount upon which the return is calculated in covered call writing.  The equation is:

Total Premium = Intrinsic Value + Time Value

Calculating time value and intrinsic value is simple.  You calculate the intrinsic value portion of the option premium, then the remainder is time value.  The entire premium of an ATM or OTM call option will to 100% time value.  The real value of option premium for sellers is the time value portion of premium.  The profit in covered call returns lies solely in time value.  

Parity simply means that the option is trading at intrinsic value which occurs to ITM options.  Options seldom trade at a few pennies below parity.  ITM options then to trade at parity when they are close to expiration or there is no expected volatility in the underlying stock.

Time decay means that the time value portion of the option premium will decay or shrink as time runs out.  The intrinsic value never decays due to the passing of time.  Time decay increases as the option nears expiration as time decay accelerates in the last 30 days of the options life.  people who write covered calls in the current expiration month are seeking income from time decay.  Remember, time value is on the side of the option seller not the buyer as time destroys the option premium of the buyers investment.

Theta is the expected change in an option premium for a single day’s passage of time.  If all other factors are the same, then option premium will be lower the next trading day by the theta value of the option.  Theta expresses time decay as an options time value.

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How To Make Money On Stagnate Stocks

After bottoming out in March 2009, the equities market bounced back with an impressive two-year march higher. But faster than you can say “Happy birthday, bull market,” violent clashes in the Middle East and utter devastation in Japan sent stocks reeling over a matter of mere weeks.
So, if you’re like most U.S. investors, you’ve probably got quite a few stocks in your portfolio that are now trading below freshly tagged multi-year highs. Since previous price peaks can act as areas of technical resistance, it’s only natural to be concerned about a forthcoming period of consolidation. Or, to be brutally honest — stagnation.

Fortunately, there’s a simple option strategy any investor can use to generate immediate income on his equity investments — even during those frustrating times when the market is grinding sideways.

A covered call is an option that you sell (or write) on a stock that you’re holding in your portfolio. By selling to open one call option, you’re accepting the obligation to deliver 100 shares of the underlying equity at the strike price of the option, should the stock price surpass the strike price, prior to the contract’s expiration date (in other words, should the option go “in the money”).

To build your cash-collecting call trade, take a look at a price chart of the security in question. You’ll need to pinpoint where you expect the shares to find resistance, because the strike price of your sold call(s) should generally correlate with this price zone.

In the best-case scenario, you want your sold call to expire worthless — or “out of the money” — so that you can (a) retain the entire premium received as pure profit; and (b) avoid taking any further action to close out the trade, which would rack up additional brokerage costs.

On the other hand, a call that’s too far away from the stock’s current price will barely be worth the effort. To see what we mean, simply check out the option chain of any given stock. As your eye travels over higher and higher strike prices, you’ll see the premiums begin to vanish.

Luckily, in the age of 1-point and 2.50-point strike prices for many popular stocks, it’s much easier than ever before to find a happy medium for your focus strike.

Once you’ve selected your ideal strike price, you’ll want to narrow your focus to shorter-term options. The comparatively richer option premiums of longer-dated contracts may be tempting, but trust us — the covered call strategy is best conducted over a relatively narrow window of time.

Put simply: The shorter the time frame of your trade, the less opportunity the shares have to rally above your focus strike. Plus, the effects of time decay are more pronounced on options that are closer to expiration — and in an option-writing strategy, time decay is your best friend. As the contracts shed their time value at an accelerating pace, they’ll naturally decline in price. This means the calls will be cheaper to buy back in the event that you should decide to liquidate your position ahead of expiration.

Investors should also be aware of the stock’s historical volatility, particularly as it relates to the option’s implied volatility. Equities with relatively low historical volatility (that is, slow-moving stocks) are attractive covered call candidates, because it suggests a relatively low probability of drastic price swings that could put you at risk of assignment. When implied volatility is inflated relative to historical volatility, it points to prime premium-selling opportunities.

On that same note, though, don’t forget to check the corporate calendar. A looming event, such as an earnings report or product launch, could be the underlying cause of inflated volatility. These events can often translate to significant price changes in the underlying stock, which raises the risk profile of a sold call position.

So, having selected an appropriate strike price and expiration month, your next responsibility is to place the trade with your broker. In order to make sure this is a covered call, be sure you sell no more than one option contract for every 100 shares of stock you own. Pocket your premium, and then sit back and wait for the options to expire worthless, as you predicted.

However, following a two-year rise in the broader equities market, it’s quite possible that you’re holding a few stocks in your portfolio that have delivered healthy returns. If you’re satisfied with the gains you’ve collected and are ready to move your investing capital elsewhere, writing covered calls is a savvy way to “get paid to get out.”

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