More Factors Affecting Covered Call Premiums
How appropriate is it that we should wrap up our discussion of covered call time premium for the week on the day before option expiration? Even though options expire tomorrow on Saturday, today is the last day that they could trade. So for all practical purposes, I consider the third Friday of the month as the more important day when it comes to trading options.
Additional Factors Affecting Options Prices
We have already discussed a couple of the factors that influence the premium that one might receive for selling a covered call and will summarize those at the end, but another important factor that can influence the price of an option contract is the volatility of the underlying stock.
This should make sense since the way to profit with an option is by having a significant change in the price of the underlying stock. If a stock only typically moves $5 in a month, you can bet that options priced $10 away from the market price have very little value. However, if the stock is highly volatile and will move $20 up or down in a month’s time, then that same contract would be worth a lot more.
Finally, one needs to consider the impact of interest rates and dividends on the premium of a call option. In a higher interest rate environment, the call premiums tend to be higher since the cost to purchase shares of stock outright with borrowed money is more. This makes a call option a viable alternative as a form of leverage and so the price increases somewhat. Of course, this will benefit those selling covered calls.
On the other hand, a stock that pays a dividend will tend to have a lower premium since the stock should be losing value when it goes ex-dividend. On a side note, dividend paying companies tend to be less volatile.
Five Factors that Influence Call Option Premiums
To summarize, there are five main factors that work together to determine the ultimate price of a covered call:
- Relationship between the stock price and the strike price
- Time until expiration
- Volatility of the underlying stock
- Prevailing interest rates
- Dividends paid by the underlying stock
That concludes this week discussing covered calls and premiums. Feel free to ask any questions or suggest topics for the future.
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Your posts are interesting but there is a lot of language to absorb in this area. As a geek I should be able to pick this all up but will probably have to spend some time studying before taking the big plunge!
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Learning the language is one of the biggest issues with any new skill.
You mentioned dividends. The one strategy I saw out there somewhere was to combine capturing dividends with covered call strategies. I suppose for higher dividend yield stocks, there might be a play there, although admittedly, usually the beta is lower on stocks like that so the premiums aren’t great.
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Right, the lower beta does impact the premiums so it can be tough to find the right combination.