## Posts Tagged ‘time value’

## 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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## Selling Time Value of Options

When selling time value, you will use a different philosophy than those stock investors looking for a stock to go up in price. Your gains will come from the time value of the options you will sell. This approach to stock selection is unusual. Most investors use fundamental analysis or technical analysis while you will use the time value of s stock’s options, tempered by fundamentals and long-term hold principles.

Deciding to create a covered call trade requires choosing an expiration month and strike price. Option strategies require making modifications during the life of an option trade. The option expiration month you select will have significant impact on the success of any option trade.

There are at least four different expiration months available for every stock on which options trade. Initially, the CBOE set up only four months for options but later LEAPS were introduced so it was possible for options to be traded for more than four months on stocks with LEAPS options. When stock options first began trading, each stock was assigned to one of three cycles: January, February or March. Stocks assigned to January cycles will offer options in the months of January, April, July and October. The same quarterly sequence will hold for the February and March option cycles. Under the new rules, the first two months are always available but for the later months the original option cycles are used.

To select a stock for your covered call portfolio, you must have available a current option chain list. You can select the expiration month based on the time value of the stock options and the strike price. Then, if the stock meets your stock selection criteria, but it as the underlying stock in your portfolio.

To get an annual return of 20% or more, you must find available options with time value that will produce a 2% return each month or 5% each three months on the price of the stock. Using the option chain list, you can calculate the percentage of stock price that the time value represents. Of all the optionable stocks, you can find at least 5 to 10 stocks to consider. If the time value seems attractive, then look at the fundamental and technical analysis to make your decisions.

Personally, I like to sell an option in the current or next month with a time value return of no less than 3%. However, I will caution all covered writers

to proceed with caution if the time value return is very high as usually there is something pending with the underlying stock such as a news event, earning

release and other items. Volatility can play a significant role in the pricing of options so the higher priced time value options usually have a significantly higher volatility.