In-The-Money Call Strikes: Intrinsic Value Protects Time Value
Dr. Alan Ellman | May 20, 2018 12:49AM ET
Strike price selection is one of the 3 required skills for covered call writing and put-selling. When we sell in-the-money call options we are protecting our positions to the downside while still generating the time value initial profits we have established in our strategy goals. In return, we are relinquishing any opportunity to generate additional profit from share appreciation. Another way to state this approach is that intrinsic value protects time value.
When to consider in-the-money call options
- Bear markets
- Volatile markets
- Pre-event (Brexit, elections, Fed watch etc.)
- Satisfies personal risk-tolerance
Methodology to select in-the-money call strikes
After establishing a watch list of eligible securities, we must select our target initial time value returns whether they are for in-the-money, at-the-money or out-of-the-money strikes. In my case, I target monthly 2% – 4% time-value in most market conditions and up to 6% returns in bull markets. For in-the-money strikes, the time value is calculated as follows:
Total option premium – Intrinsic value = Time value
Real-life example with Control4 Co (NASDAQ:CTRL)
With CTRL, a stock on our option chain for the 5-week expiration (11/15/2017):
The $30.00 in-the-money strikes shows a bid price of $3.50. We cannot count this entire premium as initial profit because we can lose $2.78 on the sale of the stock. The Ellman Calculator will deduct this intrinsic value component to yield a time value initial profit. The $2.78, however, does represent protection of the time value. Consider the intrinsic value as an insurance policy paid for by the option buyer, not by us, the option-sellers. Let’s feed this information into the multiple tab of the Ellman Calculator .
The Ellman Calculator
Get The News You Want
Once the blue cells are filled with the options chain information, the white cells will become populated. The red arrow shows the intrinsic value component of the $3.50 premium and this amount will be deducted to calculate the 2.4% initial 5-week return (yellow field). The downside protection (brown field) reflects the protection of this time value, not the breakeven (shown as $29.28). In this case the downside protection is 8.5%. This means that we are guaranteed a 5-week 2.4% return as long as share value does not decline by more than 8.5% by contract expiration. Stated differently, we are guaranteed a 2.4% return as long as share value does not decline from $32.78 to below $30.00 by contract expiration. It is important to remember that the trade-off is that should share value appreciate, we will not participate in those gains.
Discussion
Selling in-the-money call strikes offers downside protection of the initial time value profits but will not allow for additional income from share appreciation. The approach can be summarized as intrinsic value protects time value.
Market tone
This week’s economic news of importance:
- Retail sales April 0.3% (expected)
- Home builders index May 70 (last 68)
- Business inventories March 0.0% (last 0.6%)
- Housing starts April 1.287 million (1.290 million expected)
- Building permits April 1.352 million (1.377 million last)
- Industrial production April 0.7% (0.6% expected)
- Weekly jobless claims week ending 5/12 222,000 (215,000 expected)
- Leading economic indicators April 0.4% (last 0.4%)
THE WEEK AHEAD
Mon May 21st
- Chicago national activity index April
Tue May 22nd
- None scheduled
Wed May 23rd
- Markit manufacturing PMI May
- Markit services PMI May
- New home sales April
Thu May 24th
- Weekly jobless claims through 5/19
- Existing home sales April
Fri May 25th
- Durable goods orders April
- Consumer sentiment index May
For the week, the S&P 500 moved down by 0.54% for a year-to-date return of 1.47%
Summary
IBD: Confirmed uptrend
GMI : 6/6- Buy signal since market close of April 18, 2018
BCI: Selling an equal number of in-the-money and out-of-the-money for new positions.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral to slightly bullish tone. In the past six months, the S&P 500 was up 4% while the VIX (13.41) moved up by 22%.
Wishing you much success,
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