- The intrinsic value
- The time remaining until expiration
- The volatility of the underlying
- The cost of carrying the underlying interest

1) Intrinsic value:
Intrinsic value is the amount by which an option is in-the-money. The difference between the stock price and the strike price of an option determines whether the option is in-the-money, at-the-money or out-of-the-money. The deeper an option is in-the-money, the more intrinsic value and therefore, the more value is added to the option price.

2) Time value:
An option is a wasting asset. Its value declines over time. The closer the option is to expiry, the more the price of the option tends to its intrinsic value. It is logical to think that an option with more time remaining before expiry has more value since it gives more time for the price of the underlying to move up or down, giving the option more chance to move in-, at- or out-of-the-money.

3) Volatility of the underlying asset:
Volatility is the measure of the degree of price movement in the price of the underlying. Volatility is the most important factor of an option’s price. The greater an underlying asset’s volatility, the higher the option’s premium. The future volatility of an underlying is unknown and must be estimated. Historical volatility can be used to predict future volatility, but there is no guarantee that the calculated historical volatility is a good predictor of the future volatility. An alternative would be to use implied volatility,which is what the market is currently using to price the option and it reflects the anticipation of the market for the life of the option (can be found on our website under “Quotes”). Investors can compare implied volatility with historical volatility and make their own opinion about the future volatility of the underlying.

4) The cost of carrying the underlying asset:
Since calls and puts give the right to buy or sell, we can compare the advantage of holding a stock versus buying a call, or short selling a stock versus buying a put. To buy a stock, financing is needed; the investor may have to borrow money. The cost of financing considered is the risk-free interest rate. The cost of carrying the underlying is the cost of financing minus the dividends received from holding the stock. If the carrying costs increase (risk-free interest rate increases, or dividends decrease), the purchase of a call becomes a more attractive alternative and its value will increase. On the other hand, the cost of having a short position is the interest earned on the proceeds of the short sale minus the dividends paid. If the carrying costs increase, it might be more attractive for an investor to short sell a stock rather than buying a put.

These are not the only factors that may influence an option’s price. The prevailing market conditions and the rules of supply and demand may also be determinants.

Covered Writing Study
And equivalent option positions
by Richard N. Croft

Many traders believe that option-writing strategies are the only way to make money in the options game. A lot of statistics make their case with some studies suggesting that 80% or more option contracts expire worthless. Hard to imagine how any buyer could profit in that environment. And what with time working against the option buyer, premiums at record levels, commissions and the spread between bid and asked prices, how can option buyers hope to profit. Especially on a consistent basis.

These are all valid points, although they ignore the fact that for every option written, there must be someone willing to buy. You would think that if buyers were consistently losing money, buying would dry up. Would that not reduce what someone is willing to pay for an option, with the macro effect being lower option premiums. Yet, despite that, we are witnessing just the opposite. Option premiums over the past five years, have on average, traded at levels twice as high as they were pre-1997.

Obviously, it is not as straightforward as saying that when an option seller wins, an option buyer must lose. In this column, for example, we have shown many instances where both the option buyer and seller can win. Buying XYZ at $50 per share and writing a six-month XYZ call option at $5.00 per share is a typical covered writing strategy. If six months from now, XYZ closes at $58 per share, the covered writer is happy because he made a 10% profit, and the call buyer is also happy, because his call is worth $8.00 per share, for a 60% profit.

What about the XYZ covered writer who holds the position to maturity, during a period when the stock declines to say, $35 per share. The covered writer has lost $10.00 per share ($15 per share on the stock, less $5.00 premium received). The XYZ option buyer has also lost, but in this case, only $5.00 per share.

With so many seemingly conflicting points of view, it might help if we were able to look at some long-term studies that examined buying and writing strategies. There are two covered writing indexes you can look at: 1) the CBOE Buy Write Index (symbol BXM), which writes calls on the S&P 500 Index, and 2) the Montréal Exchange Covered Call Writers Index (symbol MCWX), which writes covered calls on the S&P/TSX 60 iUnits. Both indexes have more than 10 years of historical data.

Basically, we know that covered call writing carries less risk than a typical buy and hold strategy that does not involve option writing. The BXM and the MCWX were both about 80% as volatile as their respective underlying indexes.

You would expect that covered call writing being a lower risk strategy, should over the long term, under-perform a buy and hold strategy that does not involves option writing. Especially during periods when the market is rising, as it did throughout most of the 1990s.

Interestingly though, the BXM Index actually out-performed the S&P 500 Composite Index from June 1988 to present. Similar results from 1992 to present have been recorded for the MCWX.

The implication is that index option premiums were overstating the risks associated with the underlying equity markets during the test period. In other words, index option buyers were paying too high a price to play the game.

Further evidence to support that contention, can be found looking at option buying strategies over the same period. If you were buying call options from 1993 - using a long call plus T-bill strategy - a $100 investment would only have been worth less than $120 by the end of December 2002. Most of that return coming from the interest earned on the treasury bills.

The same $100 invested in a long T-bill plus long put strategy using S&P 500 Index options, would have only been worth about $100 at the end of December 2002. A breakeven proposition over that ten-year period. Under either scenario, index option buyers did not fare well.

Given such compelling evidence that index option writing is a superior strategy to index option buying, why do so many investors continue to buy index options at such high prices?

Apparently, according to some, index option traders seem willing to overpay for index options because as a trader, you only need to decide whether the market is going to rise or fall. You do not have to sub-divide the decision by trying to pick sectors or specific stocks in the market.

That may explain why so many traders continue to play index options; it does not address the question as to why one would employ option-buying strategies at all. To find that answer, you need to look beyond index options, and into equity options.

Equity options for the most part have tended to understate future volatility over the past ten years. Or to put it another way, equity options have been relatively cheap given how volatile individual stocks have been. Perhaps, and there is no scientific proof of this, traders who have been buyers of equity options may have done significantly better than those who have been buying index options. If you bought puts on Enron, Worldcom, Air Canada or AMR Corp., you would have done pretty well in the last couple of years. If you bought calls on some of the internet stories in the 1990s, you would have turned in decent profits as well.

In the end, it is probably the lure of that one big score that keeps option buyers coming to the table. In much the same way, that people continue to buy lottery tickets. You only need one to win.

Equity options are settled in shares. If you exercise a call on a stock, you get to buy the underlying shares; if you exercise a put, you would be selling the underlying shares. Index options are different in the sense that they are cash-settled. Buying a call on an index doesn't mean that you will buy the underlying index.

In your example, the SXO is a European-style option (most index options are). This means that the holder of the option can exercise his right only on expiration date. SXO options cease trading on the third Thursday of each month; the final settlement price is the official opening level of the underlying index on the expiration date, which is the Friday. Your account will be either credited or debited by the amount by which your option is in-the-money if you are assigned.

To go back to your example: If you have sold SXO put with a strike of 370 and the S&P/TSX 60 opening level is 371, your option is out-of-the-money. So there are no consequences for your account and you keep the premium. But if you have sold SXO put with a strike of 370 and the opening level of the index on expiry day is 365, your option is in-the-money by 5 points and your account will be debited by the following amount: number of contracts sold x 100 (contract multiplier) x (370-365). For one contract, it's a debit of $500. The buyer of the put will be credited with the same amount.

If you have a question about options, please send it to options@m-x.ca. Your question may be published in the next issue of this newsletter.