Covered Calls and Time Decay

Size: px

Start display at page:

Download "Covered Calls and Time Decay"

Claud Reed
6 years ago
Views:

1 1-888-options www. OptionsEducation.org your destination for options education WINTER 10 Covered Calls and Time Decay By: Russell Rhoads In this winter 2010 issue: Feature: Covered Calls and Time Decay Your options questions answered: Bid and Ask Readers quotes Common options terms New spring seminar schedu le! OIC launches Options Talk podcast series When putting on a short option position, whether it is a call or a put, one of the potential benefits of this position occurs with the passage of time. As time passes, the time value of the option decreases. However, there are some nuances to the loss of option value over time and the rate that this occurs. In this article we will discuss how the time value of an option decreases as the option approaches expiration, and what you may want to consider before entering a short option position. The rate at which time value dissipates is referred to as theta. Theta is the option Greek that indicates the change in an option s value based on a change in a specific unit of time. I use the word unit because some resources may use a different measure of time than others. To keep things simple, I will use one-day theta in this article. Just keep in mind that if the theta of an option appears high, it may be based on a unit of time higher than one day (such as seven days). Figure 1 (shown on Page 3) is a quick example of how theta works. In this example, the far-fetched assumption is made that the stock price and all other variables stay the same from one day to the next. This is not exactly a real continued inside

2 page 2 continued from front Russell Rhoads, CFA, is an instructor with The Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management in Memphis, TN, Caldwell & Orkin Investment Counsel in Atlanta, GA, and Balyasny Asset Management in Chicago, IL. He is a financial author and editor having contributed to Technical Analysis of Stocks and Commodities magazine and edited several books for Wiley publishing. Also, in 2008 he wrote Candlestick Charting For Dummies. He is a double graduate of the University of Memphis with a BBA ( 92) and an MS ( 94) in Finance and also received a Master s Certificate in Financial Engineering from the Illinois Institute of Technology in In addition to his position with CBOE, Mr. Rhoads serves as an instructor for The Options Industry Council. world scenario, but it helps to isolate the effect of time on the value of an option. The first price of this call option is $1.25, with a theta of.05. One day later, with 14 days to expiration, the option is worth $1.20 (all else staying steady), or $.05 less. The math is one day multiplied by.05, or a loss of value of $.05. The interesting thing about theta is it does not hold steady for the life of an option. For an option that is At the Money (ATM), or very close to it, the loss of time value actually accelerates toward the end of the option s life. For instance, in Figure 2, an option is depicted with all the same variables from Figure 1 except for days to expiration. With 150 days to expiration, an option loses about $.02 per day with all else being equal, while the same option loses $0.11 per day when there are five days left to expiration. This type of increase in the loss of value as time passes is typical of theta. Figure 3 is a depiction of how this occurs. As there is tremendous risk in selling options naked, or without any corresponding position to offset the potential loss from this short position, a covered call is a more palatable alternative. So Now What? Now that you ve seen how the time value of an option deteriorates at different paces based on the time to expiration, let s look at how this information is used in making trading decisions. The choices are pretty wide open, but for brevity sake, let s explore two situations where the difference in time value, or theta, is used to our advantage. Covered Call Selling an option can be a way to benefit from theta decreasing the value of an option from day to day. As there is tremendous risk in selling options naked, or without any corresponding position to offset the potential loss from this short position, a covered call is usually a more palatable Welcome to the Winter 2010 issue of Options Central The Options Industry Council s educational newsletter! from the Editor In this issue, Russell Rhoads, an instructor with The Options Institute at the Chicago Board Options Exchange (CBOE), discusses how the time value of an option decreases as the option approaches expiration. Then in the Bid and Ask section, OIC s Help Desk provides insight into what time period the theta value is in reference to, plus answers why option prices have been out of line. Don t forget to review our Readers Quotes section where fellow investors share their thoughts. We hope you enjoy reading this issue of Options Central and as always, we welcome your feedback!

page 3 Figure 1 XYZ January 30 Call @ $1.25, Theta = $.05 Days to Expiration 15 14 Option Price $1.25 $1.

3 page 3 Figure 1 XYZ January 30 $1.25, Theta = $.05 Days to Expiration Option Price $1.25 $1.20 Figure 2 50, 50 Call Option Pricing Days to Expiration Option Price 1- Day Theta 150 $6.43 -$ $5.83 -$ $4.98 -$ $4.07 -$ $3.52 -$ $2.87 -$ $2.03 -$ $1.66 -$ $1.17 -$0.12 alternative. The covered call involves owning an underlying instrument such as a stock and selling a call option against that long position. A basic covered call is shown in Figure 4. In the example, we are long 100 shares of XYZ Corporation and short one XYZ April 35 Call. Since one option contract represents 100 shares of stock, the short call is covered by the long position. Hence the name covered call, although sometimes this strategy is also referred to as a buy-write. When deciding to sell a call against a long stock position, there are factors to consider. If the stock trades above the strike price, then the stock may be called away at the strike price regardless of where the stock is trading. At expiration, if the stock is trading over the strike price, it will be automatically called away. Due to these two potential outcomes, a trader should be content with the sale of his or her stock at the strike price and the premium, or income, received for the short call option. Another factor to consider is the expiration month. This is where time value and theta come into place. Consider the following scenario. A trader is long 100 shares of XYZ Corporation at $48 per share and would be a happy seller of the stock anytime over the next 90 days at $50 or better. Conveniently, May expiration is in 30 days, June is 60 days off, and July is exactly 90 days off. The pricing for each of the 50 strike calls is shown in Figure 5. So what action should be taken? Two Covered Call Alternatives One possibility is to sell one July 50 Call for $3.94, but there is a potentially more profitable outcome, especially if the stock does not move much over the next 90 days. Take a look at the May 50 Call trading at $1.92. In 30 days, with all other factors the same, the May 50 Call will expire worthless. At that time the June Call will have 30 days to expiration and the July Call will have 60 days. Also, the June 50 Call should be trading at $1.92 and the July 50 Call would now be trading at $3.06. At this point you may decide to sell the June 50 Call at $1.92 to earn more income from your stock position, taking on the obligation to sell shares at $50 if the option is assigned. With these two transactions, you have taken in $3.84 in premium, almost the same amount you

4 page 4 One of the benefits and perhaps the most important behind taking a short position in an option is the expected loss of time value that exists in the option. would have received if you had originally sold the July 50 Call at $3.94. However you have only been obligated to sell shares for 60 days instead of 90 days. Finally, if all else stays the same, the June option would expire worthless in 30 days. The July 50 Call now has 30 days remaining until expiration and the premium would be $1.92. You may choose to sell this July 50 Call at $1.92, and be obligated once again to sell your shares at $50 over the next 30 days. With these three transactions you have taken in a total of $5.76. This is a favorable alternative to just selling one option for the 90 days and harvesting $3.94 in premium. Figure 6 summarizes these scenarios. A couple of notes regarding Figure 6 are in order. First, let s assume that the pricing variables which determine the option values remain constant over this 90-day period. This would be unusual, but for educational purposes and to demonstrate the time deterioration effect, this assumption is in place. Also, Alternative B involves two more transactions, and consequently two more commissions, than Alternative A. Time and the Calendar Spread A calendar spread using call options involves buying one call and selling another call. All characteristics of the option are the same except for the expiration date. In order to benefit from the difference in time deterioration, selling the call with less time to expiration and buying the option with more time to expiration would be the appropriate strategy. Take a look at the option quotes in Figure 7. Given the available options, the difference in time to expiration could be taken advantage of by buying the 120-day 70 Call for $5.10 and selling the 30-day 70 Call for $2.05. The cost of this position would be $3.05. In an ideal situation the stock would close slightly under $70 in 30 days, the short 70 Call would have no value, expiring worthless, and the long position would still have 90 days to expiration with a good amount of time value remaining. However there are things that may not work so well with this trade. Figure 8 shows a variety of pricing scenarios 30 days from inception of the trade with the assumption that pricing factors, other than time or price, have not changed from trade inception to expiration of the short call. Also, the assumption is made that the long call will be sold upon expiration of the short call. The results are non-linear but they do depict a good picture of what the profit or loss of a calendar spread Figure 3 Figure 4 Figure 5 Covered Call Option Prices Time Value of an Option Position Long 100 Short 1 Shares/ Contracts Instrument XYZ Stock XYZ Apr 35 Call Price $32.50 $2.10 XYZ May 50 Call $1.92 XYZ Jun 50 Call $3.06 XYZ Jul 50 Call $ Days to Expiration

page 5 Figure 6 Alternative A - Sell 1 90-Day Call * Sold 1 July 50 Call @ $3.94 Total Income = $3.94 Alternative B - Sell 1 30-Day Call 3 Times * Sold 1 May 50 Call @ $1.92 Sold 1 June 50 Call @ $1.

5 page 5 Figure 6 Alternative A - Sell 1 90-Day Call * Sold 1 July 50 $3.94 Total Income = $3.94 Alternative B - Sell 1 30-Day Call 3 Times * Sold 1 May 50 $1.92 Sold 1 June 50 $1.92 Sold 1 July 50 $1.92 Total Income = $5.76 *Assuming everything else remains constant. Figure 7 $ Day 70 Call $ Day 70 Call $ Day 70 Call $ Day 70 Call $5.10 Figure 8 30 Days Later Stock Price Short Call Long Call Spread Premium Profit or Loss (3.05) (2.40) (3.05) (1.45) (3.05) (3.05) (5.00) 8.50 (3.05) (10.00) (3.05) (0.85) 85 (15.00) (3.05) (1.80) would likely be at expiration. The position would be profitable with the stock above $65 or below $75 at expiration. The absolute best case scenario is for the stock to go out on expiration at $70 where the short option will expire worthless. Thus, the long option will have maximum value relative to the short option being worthless. Conclusion position in an option is the expected loss of time value that exists in the option. As each day passes, with all else being equal, an option should lose a little bit of value. This loss of value, however, does not occur in a linear fashion. There are ways to address it using a variety of option strategies, including the covered call and calendar spread strategies demonstrated in this article. One of the benefits and perhaps the most important behind taking a short To simplify the computations, the examples in this article do not include commissions or transaction costs. Commissions and transaction costs will affect the outcome of all stock and options transactions and must be considered prior to entering into any transaction. Investors considering options should consult their tax advisors as to how taxes may affect the outcome of contemplated options transactions. Multiple-leg strategies will involve multiple commission charges.

page 6 Common Options Terms Looking for Options? At-The-Money A term that describes an option with a strike price that is equal to the current market price of the underlying stock.

price. Example: buying 1 XYZ May 60 call (far-term portion of the spread) and writing 1 XYZ March 60 call (near-term portion of the spread).

6 page 6 Common Options Terms Looking for Options? At-The-Money A term that describes an option with a strike price that is equal to the current market price of the underlying stock. Calendar Spread An option strategy which generally involves the purchase of a farther-term option (call or put) and the writing of an equal number of nearer-term options of the same type and strike price. Example: buying 1 XYZ May 60 call (far-term portion of the spread) and writing 1 XYZ March 60 call (near-term portion of the spread). Covered Call / Covered Call Writing An option strategy in which a call option is written against an equivalent amount of long stock. Example: writing 2 XYZ May 60 calls while owning 200 shares or more of XYZ stock. Expiration Cycle The expiration dates applicable to the different series of options. Traditionally, there were three cycles. Today, equity options expire on a hybrid cycle which involves a total of four option series: the two nearest-term calendar months and the next two months from the traditional cycle to which that class of options has been assigned. For example, on January 1, a stock in the January cycle will be trading options expiring in these months: January, February, April and July. After the January expiration, the months outstanding will be February, March, April and July. Short Option Position The position of an option writer which represents an obligation on the part of the option writer to meet the terms of the option if it is exercised by its owner. The writer can terminate this obligation by buying back (cover or close) the position with a closing purchase transaction. OIC s Investor Education Day (IED) will help you develop your ability to trade Options an ideal investment for stuck markets, and stuck investors. Save the date for an upcoming IED this year! Costa Mesa, CA - March 13 Costa Mesa Hilton Atlanta, GA - May 22 JW Marriott Buckhead Want to keep track of upcoming expirations for your options? Order OIC s 2010/2011 Expiration Calendar TODAY! New York - October 5 New York Marriott Marquis Chicago - November Details Coming Soon! Space is limited so register today at OptionsEducation.org or call OPTIONS. Time Decay A term used to describe how the theoretical value of an option erodes or reduces with the passage of time. Time decay is specifically quantified by theta. The calendars are FREE and available in either a desktop- or pocket-sized version. For more information or to order, call OPTIONS or visit ww.optionseducation.org! Visit OIC s web site to download the PDF version!

7 page 7 Bid and Ask Readers Quotes Q: Over what time period is a theta value in reference to? A: Some data vendors will use a 7-day theta, others will use a 1-day theta. It is important to understand what time frame reference your resource uses. On OIC option chains, located at under the Quotes section, we use a 1-day value. Thus, if theta on our quotes page is displayed as , that specific option would lose $0.035 in value over one day at least in theory and while holding all other factors constant. writer upon expiration regardless of the length of time the call is outstanding. For more information on taxes related to options trading, check out OIC s Taxes and Investing brochure. You can download the brochure at under the Resources and Literature section, or call OPTIONS to order a free copy. Q: Recently it seems that option prices have been out of line (with intrinsic value, underling security, delta calculations, etc.). Why? Using butterflies with my condor has helped me trade the May, June, July and August cycles with more patience. I traded as a CBOE market maker for 15 years so my new hybrid persona of mixing trading plans and managing with the Greeks is a work in progress. It means planning your trade with the church of what is working now, trading your plans and really understanding the risks the Greeks help identify. Casey Platt - Chicago, IL The Investor Education Day had a great overview of each topic covered with enough detail for traders with varied levels of experience. What I liked most about this event was that the presentations were concise and to the point, the instructors didn t waste time, and the literature was very helpful. IED participant - Dallas, TX Q: I engaged in a covered call position that has since expired with the short call not being exercised. For tax purposes, is the premium received from the sale of the call considered a short-term or long-term capital gain? A: Please be advised that OIC does not assume any responsibility as tax professionals and that all tax related question are best answered by a CPA or your brokerage firm. For your specific scenario OIC s Taxes and Investing brochure states: Premium received from writing a call is not included in income at the time of receipt, but it is held in suspense until the writer s obligation to deliver the underlying stock expires. If the writer s obligation expires, the premium is short-term capital gain to the A: The price of an option is really a function of the market buyers and sellers. In other words, when more people want to own an option, there may be a rise in the price as the forces of supply and demand become more pronounced. In times of large market movement the secondary markets may experience some increased volatility. For further information on the various components of an options theoretical price, please visit our Options Pricing educational area: org/basics/options_pricing.jsp. If you are interested in additional information, you might want to take our online Options Pricing class: classes/syllabus_options_ pricing.jsp Want to let others know about a strategy that worked great for your portfolio? Have an experience to share about an educational tool that gave you some insight into options trading? The Options Industry Council invites you to submit your options experiences to be featured in Options Central. Send us your testimonials to be featured in our Readers Quotes section for our next issue! Options Central welcomes letters and questions that address articles or other options items. Submit letters to optionscentral@theocc.com. Letter submissions may be edited for space. By submitting any letter, you consent to its publication along with your name. Options Central is under no obligation to print all pieces submitted. Editor s Note - An options investor may not have typical results as stated above as there are multiple, different outcomes from strategies in options trading.

page 8 Upcoming Seminars Check out www.optionseducation.org for a complete description and schedule of OIC seminars. Below is the schedule for live seminars running throughout the spring.

8 page 8 Upcoming Seminars Check out for a complete description and schedule of OIC seminars. Below is the schedule for live seminars running throughout the spring. March 3 Parsippany, NJ - Basic 3 Boca Raton, FL - Intermediate 4 Parsippany, NJ - Intermediate 4 Boca Raton, FL - Volatility 23 Charlotte, NC - Intermediate 23 Denver, CO - Intermediate 24 Charlotte, NC - Volatility 24 Denver, CO - Volatility April 13 Philadelphia, PA - Basic 14 Philadelphia, PA - Intermediate 20 Seattle/Bellevue, WA - Intermediate 20 New York (Midtown), NY - Basic 21 Seattle/Bellevue, WA - Volatility 21 New York (Midtown), NY - Intermediate May One N. Wacker Drive, Suite 500 Chicago, Illinois OPTIONS ( ) Options involve risk and are not suitable for everyone. Prior to buying or selling options, you must read the options disclosure document, Characteristics and Risks of Standardized Options, which can be obtained from your brokerage firm, from any exchange on which options are traded, by calling OPTIONS or by writing The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois Consult your tax advisor for tax considerations. For more information If you have additional questions about options, contact your financial advisor or one of the exchanges listed here. BATS Options Exchange ; Boston Options Exchange ; Chicago Board Options Exchange THE-CBOE; International Securities Exchange ; NASDAQ OMX ; NASDAQ OMX PHLX THE-PHLX; NYSE Amex Options ; NYSE Arca SM ; The Options Clearing Corporation ; 4 Dallas, TX - Intermediate 5 Dallas, TX - Volatility 5 Boston/Cambridge, MA - Basic 6 Boston/Cambridge, MA - Intermediate 11 Wash. D.C./Alexandria, VA - Intermediate 11 Chicago, IL - Basic 12 Wash. D.C./Alexandria, VA - Volatility 12 Chicago, IL - Intermediate 18 New Brunswick, NJ - Basic 19 New Brunswick, NJ - Intermediate 25 Long Island, NY - Intermediate 26 Long Island, NY - Volatility Registration is required. The seminars listed here are FREE and held from 6 p.m. - 9 p.m. To register for a seminar or order educational materials, call OPTIONS or visit

Option Exercise and Assignment

1-888-OPTIONS www.optionseducation.org YOUR DESTINATION FOR OPTIONS EDUCATION SUMMER 08 Option Exercise and Assignment By: Peter Lusk In this summer 2008 issue: Feature: Option Exercise and Assignment