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Aug
20
More on Covered Call Writing
As you know, an option can have two types of value: intrinsic and extrinsic value.
Intrinsic value is achieved when the option moves into-the-money. If the strike price was $50 and the stock price moves to $51, the call option will have $1 of intrinsic value. If the option is out-of-the money, it has some value because it has a chance of going into-the- money. This option has no intrinsic value; just extrinsic value for its potential. However it’s important to understand that all extrinsic value decreases as time runs out for the option period.
Extrinsic Value Decay
About 20 days out from the expirations date, chances for moving into-the-money become reduced and there are fewer buyers for that month’s option at that strike price. Option traders will move on to other further out months. As a result, demand for these options fall as does the option premiums. This happens to all out-of-the money options. As a matter of fact, during the last ten days or so of the option period, the drop in premium prices accelerates to zero as the option heads to expiring worthless; after all, there will be no premium left because there will be zero chance of getting into-the- money and producing any intrinsic residual value.
If you plan to sell an option, you are always best to sell at-the-money options because they have the highest amount of extrinsic value. After all, just a bit more and the option gains intrinsic value; needless to say, there is more demand for these options and premiums are priced accordingly.
If you plan to write an option to collect premium, you are best advised to sell a front month option at-the-money. In this way, you can ride the decay as extrinsic value goes to zero and the option stays out-of-the-money. By writing short term contracts with the anticipation of not going into-the-money, you can take advantage of the ability to use this strategy repeatedly so that even small gains can compound over time.
In the “Options Mastery Course” offered by the Options University, the case is established that you are mathematically better off writing front-month contracts than writing out-month contracts.
Profit, loss and breakeven when writing Covered Call options.
The first thing you need to find out is the breakeven; the point that your position makes zero gain or loss. To figure out breakeven, all you need to do is take the stock price and subtract the call price. For example, if you sold a call for a $2 premium, and the at-the-money- strike is at $40, your breakeven would be at $38 for the stock. If the stock goes down to $38, you would lose $2 but you received $2 for selling the options, which would offset the loss.
When you write an option, your maximum profit is the premium collected. If the option goes into-the-money and is exercised, your loss will be the stock you hold, which may not be a loss at all; however, any potential gains from owning the stock is lost due to giving up your stock. Of course, the premium collected helps to offset any losses.
For more information about all things options, go to www.optionsuniversity.com
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