Covered Call Writing - What affects the price of the options?
"All else being equal, you should look for more volatile (riskier) stocks. Technically, it was all time value - the entire value of an ""out of the money"" option is time value.   What's confusing is that time value is affected by numerous variables, only one of which is time. The reason volatility is the one to look at is that all the rest are likely already intuitive to you, or are too minor an influence to worry about: Current risk-free interest rates and a stock's dividend payout during the life of the option affect the value of the call, but are usually minor infulences.   (Higher interest rates makes call values higher, and higher dividend yield makes call values lower.) Longer time to expiration will increase the value of the call, but you're pretty likely already focused on that. The strike price's proximity to the current price affects the call's value - agreeing to sell a stock 5% above current levels will pay more than agreeing to sell it 10% above current levels - but again, this is likely obvious to you. Volatility, or the percent by which the stock is likely to move up or down on a given day, is almost certainly the variable that's not already obvious. Stocks that jump all over the place have higher volatility than those that move more predictably.     The reason that options (calls and puts) cost more on higher volatility names is that options' payout is asymmetrical.  In the case of calls, the option holder gets all the upside, but none of the downside, other than what they paid for the opotion.     If one stock goes up or down $5 every day, and another goes up or down $20 every day and you could pay some fixed amount to get that stock's upside, but not have any exposure to its downside, other than that fixed amount, you'd pay more for the one that pays you $20 or $0 than you would for the one that pays you $5 or $0.    That's why higher volatility (meaning larger daily moves) makes optimum prices higher." "Here are some things to consider if you want to employ a covered call strategy for consistent returns. The discussion also applies to written puts, as they're functionally equivalent. Write covered calls only on fairly valued stock. If the stock is distinctly undervalued, just buy it. By writing the call, you cap the gains that it will achieve as the stock price gravitates to intrinsic value. If the stock is overvalued, sell it, or just stay away. As the owner of a covered call position, you have full exposure to the downside of the stock. The premium received is normally way too small to protect against much of a drop in price. The ideal candidate doesn't change in price much over the life of the position. Yes, this is low volatility, which brings low option premiums. As a seller you want high premiums. But this can't be judged in a vacuum. No matter how high the volatility in absolute terms, as a seller you're betting the market has overpriced volatility. If volatility is high, so premiums are fat, but the market is correct, then the very real risk of the stock dropping over the life of the position offsets the premium received. One thing to look at is current implied volatility for the at-the-money (ATM), near-month call. Compare it to the two-year historical volatility (Morningstar has this conveniently displayed). Moving away from pure volatility, consider writing calls about three months out, just slightly out of the money. The premium is all time value, and the time value decay accelerates in the final few months. (In theory, a series of one-month options would be higher time value, but there are frictional costs, and no guarantee that today's ""good deal"" will be repeatable twelve time per year.) When comparing various strikes and expirations, compare time value per day. To compare the same statistic across multiple companies, use time value per day as a percent of capital at risk. CaR is the price of the stock less the premium received. If you already own the stock, track it as if you just bought it for this strategy, so use the price on the day you wrote the call. Along with time value per day, compare the simple annualized percent return, again, on capital at risk, measuring the return if a) the stock is called away, and b) the stock remains unchanged. I usually concentrate more on the second scenario, as we get the capital gain on the stock regardless, without the option strategy. Ideally, you can also calculate the probability (based on implied volatility) of the stock achieving these price points by expiration. Measuring returns at many possible stock prices, you can develop an overall expected return. I won't go into further detail, as it seems outside the scope here. Finally, I usually target a minimum of 25% annualized if the stock remains unchanged. You can, of course, adjust this up or down depending on your risk tolerance. I consider this to be conservative." Matthew - what was the stock price and strike price of the option when you did this? I've never seen an at-the-money strike with only a month to run have a price 25% of the underlying stock. Jaydles covers the variables really well in his answer. There are some excellent responses to this question at the time of this post. I have had the greatest success writing 1-month options. The 2 main reasons are as follows: With little time to expiration as stated in the question the implied volatility of the option is dictating the premium. Looking for the highest premiums is a mistake because you are taking a conservative strategy and re-creating it into a high-risk strategy. My sweet spot is a 2-4% monthly return for my initial profit and then mastering management techniques to protect that return and even enhancing it.
If you already own shares in a company and sell some, you won't be short selling these shares if sold from the same brokerage account, because your existing shares with that broker need to be sold first before you are able to short sell any. If you own a portfolio of shares however, you may be able to short sell an index to hedge your current portfolio. Also, if you have your existing shares in a company but don't want to sell your existing shares, for example you don't want to crystallise a capital gain, you can always hedge you current shares by short selling them through a different broker.  Some other hedging options possibly available to you include: buying put options over the shares, writing cover call options, or short selling some other derivatives like CFDs (if your country allows them). (Note: I am omitting the currency units.  While I strongly suspect it's US$ I don't know from the chart.  The system works the same no matter what the currency.) A call or a put is the right to sell (put) or buy (call) shares at a certain price on a certain day. This is why you see a whole range of prices.  Not all possible stock values are represented, the number of possibilities has to be kept reasonable.  In this case the choices are even units, for an expensive stock they may be spaced even farther apart than this. The top of the chart says it's for June.  It's actually the third Friday in the month, June 15th in this case.  Thus these are bets on how the stock will move in the next 10 days. While the numbers are per share you can only trade options in lots of 100. The left side of the chart shows calls.  Suppose you sell a call at 19 (the top of the chart)  The last such trade would have gotten you a premium of 9.70 per share (the flip side of this is when the third friday rolls around it will most likely be exercised and they'll be paying you only 19 a share for a stock now trading at something over 26.)  Note the volume, bid and ask columns though--you're not going to get 9.70 for such a call as there is no buyer.  The most anybody is offering at present is 7.80 a share. Now, lets look farther down in the chart--say, a strike price of 30.  The last trade was only .10--people think it's very unlikely that FB will rise above 30 to make this option worthwhile and thus you get very little for being willing to sell at that price.  If FB stays at 26 the option will expire worthless and go away.  If it's up to 31 when the 15th rolls around they'll exercise the option, take your shares and pay you 30 for them.  Note that you already gave permission for the trade by selling the call, you can't back out later if it becomes a bad deal. Going over to the other side of the chart with the puts: Here the transaction goes the other way, come the 15th they have the option of selling you the shares for the strike price.  Lets look at the same values we did before.  19?  There's no trading, you can't do it. 30?  Here you will collect 3.20 for selling the put.  Come the 15th they have the right to sell you the stock for 30 a share.  If it's still 26 they're certainly going to do so, but if it's up to 31 it's worthless and you pocket the 3.20 Note that you will normally not be allowed to sell a call if you don't own the shares in question.  This is a safety measure as the risk in selling a call without the stock is infinite.  If the stock somehow zoomed up to 10,000 when the 15th rolls around you would have to come up with the shares and the only way you could get them is buy them on the open market--you would have to come up with a million dollars.  If there simply aren't enough shares available to cover the calls the result is catastrophic--whoever owns the shares simply gets to dictate terms to you.  (And in the days of old this sometimes happened.) Option contracts typically each represent 100 shares. So the 1 call contract you sold to open (wrote) grants the buyer of that option the right to purchase your 100 shares for $80.00 per share any time before the option expiration date. You were paid a gross amount of $100 (100 shares times $1.00 premium per share) for taking on the obligation to deliver should the option holder choose to exercise. You received credit in your account of $89.22, which ought to be the $100 less any trading commission (~$10?) and miscellaneous fees (regulatory, exchange, etc.) per contract. You did capture premium. However, your covered call write represents an open short position that, until either (a) the option expires worthless, or (b) is exercised, or (c) is bought back to close the position, will continue to show on your account as a liability. Until the open position is somehow closed, the value of both the short option contract and long stock will continue to fluctuate. This is normal. "Cart's answer describes well one aspects of puts: protective puts; which means using puts as insurance against a decline in the price of shares that you own.  That's a popular use of puts.  But I think the wording of your question is angling for another strategy: Writing puts. Consider: Cart's strategy refers to the buyer of a put.  But, on the transaction's other side is a seller of the put – and ultimately somebody created or wrote that put contract in the first place!  That first seller of the put – that is, the seller that isn't just selling one they themselves bought – is the put writer. When you write a put, you are taking on the obligation to buy the other side's stock at the put exercise price if the stock price falls below that exercise price by the expiry date.  For taking on the obligation, you receive a premium, like how an insurance company charges a premium to insure against a loss. Example:  Imagine ABC Co. stock is trading at $25.00.  You write a put contract agreeing to buy 100 shares of ABC at $20.00 per share (the exercise price) by a given expiration date.  Say you receive $2.00/share premium from the put buyer.  You now have the obligation to purchase the shares from the put buyer in the event they are below $20.00 per share when the option expires – or, technically any time before then, if the buyer chooses to exercise the option early. Assuming no early assignment, one of two things will happen at the option expiration date: ABC trades at or above $20.00 per share. In this case, the put option will expire worthless in the hands of the put buyer.  You will have pocketed the $200 and be absolved from your obligation.  This case, where ABC trades above the exercise price, is the maximum profit potential. ABC trades below $20.00 per share.  In this case, the put option will be assigned and you'll need to fork over $2000 to the put buyer in exchange for his 100 ABC shares.  If those shares are worth less than $18.00 in the market, then you've suffered a loss to the extent they are below that price (times 100), because remember – you pocketed $200 premium in the first place.  If the shares are between $18.00 to $20.00, you're still profitable, but not to the full extent of the premium received. You can see that by having written a put it's possible to acquire ABC stock at a price lower than the market price – because you received some premium in the process of writing your put.  If you don't ""succeed"" in acquiring shares on your first write (because the shares didn't get below the exercise price), you can continue to write puts and collect premium until you do get assigned. I have read the book ""Money for Nothing (And Your Stocks for FREE!)"" by Canadian author Derek Foster.  Despite the flashy title, the book essentially describes Derek's strategy for writing puts against dividend-paying value stocks he would love to own.  Derek picks quality companies that pay a dividend, and uses put writing to get in at lower-than-market prices.  Four Pillars reviewed the book and interviewed Derek Foster: Money for Nothing: Book Review and Interview with Derek Foster. Writing puts entails risk.  If the stock price drops to zero then you'll end up paying the put exercise price to acquire worthless shares!  So your down-side can easily be multiples of the premium collected.  Don't do this until and unless you understand exactly how this works.  It's advanced. Note also that your broker isn't likely to permit you to write puts without having sufficient cash or margin in your account to cover the case where you are forced to buy the stock.  You're better off having cash to secure your put buys, otherwise you may be forced into leverage (borrowing) when assigned.  Additional Resources: The Montreal Exchange options guide (PDF) that Cart already linked to is an excellent free resource for learning about options.  Refer to page 39, ""Writing secured put options"", for the strategy above. Other major options exchanges and organizations also provide high-quality free learning material:" "So, if an out-of-the-money option (all time value) has a price P (say $3.00), and there are N days... The extrinsic value isn't solely determined by time value as your quote suggests. It's also based on volatility and demand. Here is a quote from http://www.tradingmarkets.com/options/trading-lessons/the-mystery-of-option-extrinsic-value-767484.html distinguishing between extrinsic time value and extrinsic non-time value: The time value of an option is entirely predictable. Time value premium declines at an accelerating rate, with most time decay occurring in the last one to two months before expiration. This occurs on a predictable curve. Intrinsic value is also predictable and easily followed. It is worth one point for every point the option is in the money. For example, a call with a strike of 30 has three points of intrinsic value when the current value of the underlying stock is $33 per share; and a 40 put has two points of intrinsic value when the underlying stock is worth $38. The third type of premium, extrinsic value, increases or decreases when the underlying stock changes and when the distance between current value of stock and strike of the option get closer together. As a symptom of volatility, extrinsic value may be greater for highly volatile underlying stock, and lower for less volatile stocks. Extrinsic value is the only classification of option premium that is unpredictable. The SPYs you point out probably had a volatility component affecting value. This portion is a factor of expectations or uncertainty. So an event expected to conclude prior to expiration, but of unknown outcome can cause theta to be higher than p/n. For example, a drug company is being sued and the outcome of a trial will determine whether that company pays out millions or not. The extrinsic will be higher than p/n prior to the outcome of the trial then drops after.  Of course, the most common situation where this happens is earnings. After the announcement, it's not unusual to see a dramatic drop in the extrinsic portion of options. This is why sometimes a new option trader gets angry when buying calls prior to earnings. When 'surprise' good earnings are announced as hoped, the rise is stock price is largely offset by a fall in extrinsic value giving call holders little or no gain! As for the reverse situation where theta is lower than p/n would expect? Well you can actually have negative theta meaning the extrinsic portion rises over time. (this statement is a little confusing because theta is usually described as negative, but since you describe it as a positive number, negative here means the opposite of what you'd expect).  This is a quote from ""Option Volatility & Pricing"". Keep in mind that they use 'positive' theta to mean the time value increases up over time: Is it ever possible for an option to have a positive theta such that if nothing changes the option will be worth more tomorrow than it is today? When futures options are subject to stock-type settlement, as they currently are in the United States, the carrying cost on a deeply in-the-money option, either a call or a put, can, under some circumstances, be greater than the volatility component. If this happens, and the option is European (no early exercise permitted), it will have a theoretical value less than parity (less than intrinsic value). As expiration approaches, the value of the option will slowly rise to parity. Hence, the option will have a positive theta. Sheldon Natenberg. Option Volatility & Pricing: Advanced Trading Strategies and Techniques (Kindle Locations 1521-1525). Kindle Edition." You could try to refine your options strategy:  For instance you could buy the USD 750 call option(s) you mentioned and at the same time sell (short) call options with a higher strike price, which is above the share price level you expect that Apple will trade at in one year (for instance USD 1,100).  By doing this, you would receive the premium of the call option(s) with the higher option, which in turn would help you finance buying your USD 750 call(s). The net effect of this trading strategy would be that you would give up the extra profit you would earn if Apple would rose above USD 1,100 (the strike price of the call option sold short). Your total risk would be even less than with your actual strategy (in my view). In a simple world yes, but not in the real world. Option pricing isn't that simplistic in real life. Generally option pricing uses a Monte Carlo simulation of the Black Scholes formula/binomial and then plot them nomally to decide the optimum price of the option. Primarily multiple scenarios are generated and under that specific scenario the option is priced and then a price is derived for the option in real life, using the prices which were predicted in the scenarios.  So you don't generate a single price for an option, because you have to look into the future to see how the price of the option would behave, under the real elements of the market. So what you price is an assumption that this is the most likely value under my scenarios, which I predicted into the future. Because of the market, if you price an option higher/lower than another competitor you introduce an option for arbitrage by others. So you try to be as close to the real value of the option, which your competitor also does. The more closer your option value is to the real price the better it is for all. Did you try the book from Hull ? EDIT: While pricing you generally take variables which would affect the price of your option. The more variables you take(more nearer you are to the real situation) the more realistic your price will be and you would converge on the real price faster. So simple formula is an option, but the deviations maybe large from the real value. And you would end up loosing money, most of the time. So the complicated formula is there for getting a more accurate price, not to confuse people. You can use your formula, but there will be odds stacked against you to loose money, from the onset, because you didn't consider the variables which might/would affect the price of your option. Not necessarily though, since you can simply adjust the premium. I'm thinking an embedded option is just an option with longer maturity, and the increased price of that adjusted option can be reflected (like any other option) in the strike price or the premium. Am I missing something?