More on Covered Calls and Time Value
In the last post, we learned that the greatest time premium for a given expiration date occurs when the strike price is close to the market price. So the relationship between these two prices ends up looking like a bell-shaped curve. Now let’s look at another factor which influences the amount of time premium.
Time Until Expiration
It should only make sense that the amount of time premium should be greater if the amount of time is longer. An option contract that expires in one month will cost less (or sell for less) than one that expires in one year. Again using actual data at the time of this writing for Silver Wheaton stock (SLW), I have created the following chart of premium versus time for the call option with a strike price of 30.
Now at first glance it would seem that selling calls that expire in two years would be smarter than selling calls that expire in one month. However, you have to remember that the graph is not to scale and to make a more fully informed decision, we should divide the amount of premium by the number of months until expiration. When we do this, we find that the shape of the graph changes dramatically as you can see below.
So we could sell the call option expiring in 2 years for $8.65 per share, or the one that expires in a month for $2.02 per share. When it expires, then sell the next one for $1-2 per share and repeat the process month after month making $30 or more in covered calls premiums over the course of two years.
Practical Application
For me, I am interested in making money from selling call options in my retirement account so I will sell them about one month out on average. Sometimes I may wait to see if the market will have a good day and end up selling them 2 weeks away. If I miss that window, I may end up selling covered calls that expire in 6 weeks.
Now if you want to purchase calls, then it is wise to purchase them to expire later so that you get more for your money, and the stock has more time to move in the direction that you would anticipate which would be higher. After all, the way to profit from purchasing a call is to sell it at a higher price which can only occur when the stock increases in price.
Again, I think that this is a very important concept to grasp and understand, namely, the time value per unit of time is greatest with the options that expire sooner. Feel free to ask any questions.
I like how you used 2 graphs to explain the premium, short and clean. Enjoyed your post!
BeatingTheIndex recently posted..Palliser Oil & Gas: Rejuvenating Old Oil Fields Using a Game Changing Methodology
Thank you. I especially think it was important to see the bell shaped curve. I think that most fail to visualize that concept.
Love the detail, but I’m probably going to just go and try do this to truly understand it. Have no doubt I’ll be hitting you up for advice!
Shaun @ Money Cactus recently posted..Wealth Creation and the Secret to Happiness
I’ll try this to see if I can generate some extra income as well. As soon as the broker approves the option trading and I buy some more T.
retirebyforty recently posted..Are you falling down the frugality rabbit-hole?
Read tomorrow’s post about some additional factors that affect time value especially dividends in the case of T.
I am also a doer by nature and learn by making my own mistakes. Feel free to ask whatever you want. It might be good fodder for a post or two.
Good advice on using a tax-sheltered account! Thanks for the tutorial!
Moneycone recently posted..10 ETFs Cheaper Than Their Vanguard Peers
No problem. Not having to deal with taxes is great for working with options.
Reading your posts makes me want to create a tax account call “play” money and just try a few things out.
My question. What length of time do you typically set your option contracts? and Why?
YFS recently posted..Can I Survive At the Poverty Line?
I usually go 1-2 months because the amount of premium is greatest. Time decay happens in the last few weeks so you can make a lot of premium one month at a time. Now remember that I am trading in a tax advantaged account and don’t have to worry about short term gains. That will be a consideration in a taxable account.
YFS – It’s really a low risk strategy and many people sell covered calls in their “non-play” account. It acts like a dividend, assuming the position doesn’t get called away.
Also, to clarify, I think it’s important to distinguish the CFM is talking about “out of the money” covered calls here, I believe. Otherwise, you probably wouldn’t keep the shares.
AverageJoe recently posted..Stop Reading About Last Year’s Top Ten Mutual Funds
I am typically working with “out of the money” calls, but will occasionally sell “in the money” so as to capture some extra premium in a bearish market. It can work both ways.