Stock options provide traders and investors with a lot of flexibility when leveraging returns or generating income. While there are many different strategies, success often boils down to a consistent, risk-managed approach. Option sellers must consider the balance between high volatility and stock ownership to create a portfolio that meets their income needs. Let’s look at what influences option premiums and strategies that you can use to capitalize on high option premiums.
What Influences Option Premiums?
Option premiums represent the intrinsic and extrinsic value of an option. While the intrinsic value is easy to calculate, the extrinsic value consists of time value and implied volatility. These values are harder to compute, predict, and interpret, making them extremely important to understand to maximize option income over the long run.
The intrinsic value is the difference between the underlying stock’s price and the option’s strike price. For example, if an option has a strike price of $100 and the underlying stock is trading at $110, then the option’s intrinsic value is $10. Thus, owners of the option can purchase the stock for a $10 discount compared to buying it on the open market. All in-the-money options have an intrinsic value.
The time value is the difference between the price of an option and its intrinsic value. For example, suppose that the option in our previous example—with an intrinsic value of $10—is selling for $15. The $5 time value represents the cost of holding the option until it expires—a cost that tends to decrease over time as the expiration date approaches. An out-of-the-money option consists entirely of time value and volatility. It has no intrinsic value.
The implied volatility (IV) is the expected fluctuation in the underlying stock’s price. Using a complex formula, the metric incorporates the supply and demand of options and changes in the underlying stock’s price over time to derive expected price movements. You can find the implied volatility of any stock option using online calculators or other tools.
How to Capitalize on High Premiums
Just like stocks, you can evaluate whether an option is over or undervalued. As an option seller, you benefit by identifying and selling overvalued options. For example, an investor might try to sell covered call options on stocks where they believe implied volatility will decrease. After all, the decrease in IV makes it less likely that the buyer will exercise the option and increase the likelihood of the seller keeping the stock and premium.
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There are many scenarios in which an option may become overvalued:
- A sudden market decline could increase implied volatility and create an opportunity to profit if the market stabilizes.
- Upcoming earnings announcements could lead to an increase in implied volatility and create an opportunity.
- Industry events could cause a spike in implied volatility and create an opportunity in stocks that aren’t as affected.
Covered calls are a great addition to reduce risk when speculating on short-term movements in a stock’s price. For instance, you might purchase stock after a sudden decline and write a call option against it. If the stock declines further, the option premium provides a buffer. Conversely, if the stock rises, you make money on the underlying stock and get to keep the premium income.
When using covered calls, you should look at the flat return and the if-called return. The flat return is the return assuming that the stock price remains the same through expiration. On the other hand, the if-called return assumes that the option is exercised—even if it’s out-of-the-money. Both scenarios are worth exploring before making a trade.
More advanced strategies to capitalize on overvalued options include:
- Selling naked puts
- Selling naked calls
- Bear call credit spreads
- Bull put credit spreads
- Butterfly spreads
- Iron butterfly
The right strategy depends on your risk tolerance and experience with different options strategies. For example, selling naked calls and puts requires a margin account and entails a lot of risks. In addition, you could be on the hook for unlimited losses in the case of a naked call since there’s no limit to how high a stock price can rise.
Where to Find Opportunities
Stock option screeners provide the best way to find stock options with attractive premiums without manually flipping through thousands of different option chains. In addition to sorting opportunities by return potential, many screeners provide metrics designed to help you avoid risky situations, such as upcoming earnings or dividends.
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There are many different covered call screeners out there, including some provided for free by brokerage platforms. Snider Advisors also provides a free covered call screener that makes it easy to find attractive opportunities. For example, you can quickly access metrics like the return if called and downside protection and earnings dates and ex-dividend dates that could impact the profitability of a covered call position over time. We also developed a more advanced covered call and cash-secured put screener to meet the needs of option sellers. OptionDash includes all the advanced screening criteria you can imagine and three proprietary scoring systems to help investors quickly evaluate stocks.
Other premium (paid) options include:
- BarChart
- Optionistics
- BornToSell
Covered call investors should look for stocks they’re comfortable owning since they may need to keep them. In addition, the stock should have good liquidity, a price of more than $10.00 per share, and implied volatility that’s at a reasonable level below 60%. Finally, it would be best to double-check there are no upcoming dividends or other significant events.
The Snider Investment Method provides a well-defined system to generate income from options and ensure cash flow in retirement. In addition to identifying opportunities (e.g., screening), the system helps you find the ideal strike prices, expiration dates, and allocations while addressing frequent concerns, like what to do if the stock price drops.
Snider Advisors’ Lattco trading platform combines an option screener, automated trading, portfolio management, and sector diversification to build a holistic strategy. The platform is available exclusively to Snider Investment Method graduates.
The Bottom Line
Many factors influence option premiums, including intrinsic and extrinsic values. Simply finding a call option selling for a high price may not work well since the company could be in the middle of a volatile period like earnings. A steep drop in price can quickly offset the income earned from the sale of a covered call. Option screeners can help you pinpoint these opportunities, but you also need to vet them to ensure there aren’t any concerns with the underlying stock.
If you’re interested in generating income from options, the Snider Investment Method provides an easy-to-use strategy and platform. Take our free e-course or learn about our asset management services.
