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.

 

Enhanced by Zemanta
Related Posts Plugin for WordPress, Blogger...
Shop Amazon Here