Mr. Kadavy has answered the following questions from readers that may be helpful to others. If you have a question, please use the "E-mail Me" button above. Answers will be provided by return e-mail and, if applicable to a broad cross-section of readers, will be posted to this page:
Q. Option premiums have declined over the last few years making put and call writing less lucrative than they were previously. Why has this happened?
A. During the late nineties and early in the turn of the century, there was a great deal of volatility in the market. Stock prices were rising rapidly. After the Nasdaq bubble burst and the markets reversed course, much volatility still existed. During both of these periods volatility was high, even thought the markets were moving in opposite directions. In the last few years markets have experienced some of the lowest volatility seen in many years. Since the size of option premiums is greatly influenced by market volatility, premiums have narrowed substantially. Also, interest rates have been at decades-long lows for much of the past few years. This is another factor that influences premium amounts, although to a much lesser degree than market volatility. While other influences may also be affecting option premiums, the low volatility is the key. The good news is that double-digit returns are still possible in this environment. And if volatility should increase in the future, greater returns from option writing will be possible.
Q. I'm a little confused by the terminology. Your book says that if a call option is out-of-the-money, there is no intrinsic value. Why can't it have a negative intrinsic value? Total option price = intrinsic value + time value (according to the book). Assume the share price is $28, the strike price is $30 and the option premium is $2.50. Your equation = $0 + $2.50. Why not = -$2.00 + $4.50?
A. The simple answer to your question is that there is no such thing as "negative intrinsic value." By definition, intrinsic value in a covered call writing situation is the amount by which the market price of a stock is above the strike price. At any given moment, the tradeable value of a call option is determined by a number of things. Volatility of the underlying stock is one. The market price of the shares in relation to the strike price is another. The time to expiration is the third (there are other factors, but these three are the principal ones). For any given option, there can be intrinsic value at times and not at other times, depending on the movements of the share price in relation to the strike price. The "time value" can then be computed by taking whatever the intrinsic value is at the moment and subtracting that amount from the currently quoted option price. If the option is at-the-money or out-of-the-money all of the value in the option contract is time value. Perhaps the best way to describe this is to state what happens on the expiration date. On the date the option expires, if the strike price of an option is $30 and the underlying shares are trading at $32, the option contract will be trading right at $2 at the end of the day because there is $2 of intrinsic value and no time left for there to be any time value.