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Strategies & Market Trends : The Covered Calls for Dummies Thread -- Ignore unavailable to you. Want to Upgrade?

To: FaultLine who wrote (1350)	7/6/2001 12:38:12 PM
From: Uncle Frank	Read Replies (1) \| Respond to of 5205

>> Anyone interested in giving me a "common sense" explanation? You're looking in the wrong place. Any one with a smidgen of common sense wouldn't be messing with options. duf

To: FaultLine who wrote (1350)	7/6/2001 7:10:33 PM
From: EnricoPalazzo	Respond to of 5205

[Stock has dropped, yet time premium of ITM calls has increased] Frankly, this seems counter-intuitive to me as we now have less time to expiry than on Tuesday and the expectations for this call have declined since Tuesday. Clearly the mathematical predictions are correctly realized, but at a gut level I don't get it. Anyone interested in giving me a "common sense" explanation?* It would indeed be surprising if the overall premium had increased, but the time premium is really a function of several different things. One of those things is the time to expiry--all things being equal, passage of time would reduce the time premium. But all things aren't equal. Think of it this way. For an ITM call, the time premium is really the value of the right not to exercise (interest is also a factor). That's why a $5 July QCOM call probably has about no time premium. You could simulate your July 55 call without the right not to exercise by buying QCOM at $59.20, and borrowing $55. Ignoring interest, that would cost you $4.20 (you'd also need a pretty lax broker!). The only difference between that and the option is that if the stock ends up below $55, you don't have to exercise the option. Given that, think of it this way: isn't the right not to exercise the call that's $4 ITM more valuable than the one that's $9 ITM? That overwhelms the minor difference in time to expiry (3 days). Sorry if that's not common sense--I didn't learn much before I was 18 <gg>. ardethan@lessonsincommonsensefromarmbsinvestor.ugh

To: FaultLine who wrote (1350)	7/6/2001 7:34:50 PM
From: Dr. Id	Read Replies (1) \| Respond to of 5205

So Ken, What's the plan on those Q July calls? Seems like you guys got a reprieve! Take advantage of it and buy them back, or wait to see if it goes lower? Dr.Id@toughcalls.com

To: FaultLine who wrote (1350)	7/6/2001 8:33:36 PM
From: Thomas Tam	Read Replies (1) \| Respond to of 5205

Simply put, volatility. Large stock price moves both up and down have contributed to the increased time premium. I hope that was simple. Later

To: FaultLine who wrote (1350)	7/6/2001 10:16:25 PM
From: LemurHouse	Respond to of 5205

<<<<this seems counter-intuitive to me as we now have less time to expiry than on Tuesday and the expectations for this call have declined since Tuesday. Clearly the mathematical predictions are correctly realized, but at a gut level I don't get it. Anyone interested in giving me a "common sense" explanation?*>>>> While it is hard to argue with U. Frank's observation that you are by definitiion looking in the wrong place for a "common sense" explanation (good one Frank!) I think your answer lies in volatility, and the market's perception of risk/opportunity that the option will be exercised. The "time" component of time premium will decay at a somewhat predictable rate, but it is only one of several factors influencing the total option price, or even of the "time premium" portion of the price." Moreover, its effect is gradual, until the very end of the term when it becomes the driving factor. For day to day price movements, volatility is the thing. The greater the volatility of the underlying, the greater the potential for profit -- or the risk of loss, depending on which side of the transaction you are on. And, the greater the potential for profit (or loss), the higher the premium that buyers will be willing to pay, and that sellers will demand. Further, the closer the underlying is to the strike price, the greater the potential for the option to move into (or out of) the money and be exercised. On the other hand, when the underlying is farther away from the strike price, it is relatively more difficult for the stock to move far enough to reach the more remote strike price. Therefore it is natural for time premium to be at its greatest when the underlying is right at the strike price, and to decline as it moves away. Higher risk requires higher return. In the example you gave, I think the sharp move of the underlying towards the strike price, and the increased volatility of both the underlying and the overall market would affect the time value much more than the decay of three days when there are more than two weeks' remaining in the option period. FWIW. AD

To: FaultLine who wrote (1350)	7/8/2001 7:45:15 PM
From: Dan Duchardt	Respond to of 5205

dfl, One thing that might help is to think in terms of the rate of change of an option value as being the probability of the option closing ITM. The quantity that measures this rate of change is delta, and for near term ATM options it is always near .5, a 50-50 chance of closing in the money. For strikes far OTM it is near zero, and for strikes far ITM it is near 100%. "Common Sense" suggests that probability changes smoothly as the stock price changes, and also suggests a smooth relationship between that probability and the total value of an option in relation to the stock price. These common sense ideas are reflected in the behavior of option prices. Your intuition is leading you to want a similar behavior for time value alone, and that works nicely for OTM calls where the value increases with the probability of the option having value at expiration. Where intuition goes awry is that it is only in this OTM region where time value is all there is. As soon as you cross into the ATM region, convention requires we identify the difference between underlying value and strike as "intrinsic value", and all that remains as "time value". If time value were that smoothly varying thing your gut wants it to be, the full value of the option would have to exhibit the sudden change in the rate of value increase that characterizes intrinsic value. There would have to be a sudden increase in the rate at which option value increases with the underlying (a sudden change in the rate of probability increase), and that would be intuitively very disturbing. Your are certainly correct when you observe that expectations for this call have declined since Tuesday, but those expectations are properly realized in the full value of the option, not in one part that is the "leftover" of a naming convention. Something I find useful for near term options is the notion that in the short run the option chain embodies all the expectations one needs. Except for the fact that each day some amount of time premium is going to erode, and a sudden change in volatility can add or subtract time value across the board, the value of the option that is ATM today is the value of the option that is ATM tomorrow. Similarly the $5 ITM option today is the price of the $5 ITM option tomorrow. I think if you have access to the prices over the last few days you will find that the price of the JUL55 now is very close to the price the JUL60 had when the stock price was $5 higher the day before. In other words, the option price as related to how far OTM or ITM is quite stable from one day to the next. It think that is intuitively satisfying. For those who want to estimate the effects of time and volatility changes, the "greeks" tell the story. Right now "theta" for both the JUL55 and JUL60 is a bit over 0.11, so if the stock price does not move you can expect these calls to drop a dime a day. For most of us, that is not much of a concern compared to the effects of price movement of the underlying. Dan