Writing Covered Calls – The Anatomy of an Option

Writing covered calls for monthly or even weekly profit sounds extremely rewarding. But as you study your options quote page you start to think that maybe you’re missing something.  Not to worry, no long high school lectures here, just a brief synopsis of the basic anatomy of an option.

 

One important aspect of any option is the expiration. Expiration is the date that the option must either be exercised on or it will become worthless. An option would be exercised by the individual who bought the option, never the seller or writer of the option. For illustration purposes we will explore monthly options since they are the vast majority of options traded.  Weekly options are only available on a select number of stocks.

 

Options are usually referred to by expiration and strike price. For example a July 35 call would be the July call option at the $35 strike price. This option would expire at the close of trading the third Friday in July. In addition to the month of expiration you will also see the year displayed. This may seem like an overstatement since you obviously know what year it is. But there are options that have a longer expiration time known as LEAPS which can be bought or sold up to three years out.

 

You may notice that an option’s price may fluctuate on its way towards expiration Friday. There are many reasons for this behavior. The first of course is tied to the fluctuation of the underlying stock. With a call option, as the price of the stock rises so does the price of the option.

 

If the stock heads lower, the value of a call option will decrease as well. Put options work in exactly the opposite way. As a stock’s price heads south, the price of a put will actually increase in value. And when a stock’s price increases the put option will lose value.

 

It is equally important to understand the value component of an option. This consists of intrinsic value and time value. Intrinsic value is in direct relation to how close the stock price is to the strike price of the option. Time value takes in consideration how much time is left until the option expires. Call options have more intrinsic value the higher the stock is over the strike price.

 

For example if stock ABC is trading at $17, a $15 call option would have $2 of intrinsic value. If the price of ABC stock was $14, a $15 call option would have no intrinsic value as the stock is trading for less than the option price guarantees.

 

A put option’s intrinsic value increases as the stock decreases. If XYZ stock is trading at $27 then the $30 put option would have $3 of intrinsic value. The lower the stock price the more intrinsic value the put option would gain. The closer the stock is to $30 the less intrinsic value the put option commands. If the stock were to trade above $30 the put option would have no intrinsic value.

 

Understanding what elements make up an option is an important tool when writing covered calls. Always remember to consider these components when researching what options you wish to sell.

                                                                   

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