With fiat currency interest rates at historic lows, investors are searching for higher yields. Many investors have turned to volatility as an “asset class” as a way to pick up more yield for their portfolios. This is evidenced by the emergence of various VIX ETFs and retail volatility products. Options are a good way to capture volatility premiums and are suitable for sophisticated retail investors. I believe retail investors can obtain alpha for their portfolios by incorporating simple option trading strategies. Below, I describe one simplified way to calculate the “yield” of an option.
There are two factors that determine an option’s value: intrinsic value and time value. The intrinsic value of an option is the portion of an option’s value that is determined by its “in the money” characteristics. If a call option’s strike price is $10 and the underlying is trading at $15, then this option is “in the money” by $5 and so that is its intrinsic value. An option’s intrinsic value is equal to how much the option is trading “in the money”. Options that are “out of the money” have no intrinsic value. Time value by contrast is any amount of an option’s value outside of its intrinsic value. An option’s time value also includes its volatility premium.
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The first step to determining an option’s “yield” is to separate the intrinsic value from the time value. Consider the underlying symbol MSFT trading at 57.87. The 1 month 47.00 calls are trading at 11.00, so they have an intrinsic value of 10.87 and a time value of 0.13. Alternatively, the 1 month 60.00 calls are trading at 0.62, of which all is time value since these options are trading just over 2.00 out of the money.
Once we have identified the option’s time value, we can then compare the cash flow yield of each option. The “in the money” option has a time value of 0.13 and an underlying price of 57.87. To write a covered call, the investor is risking capital of 57.87 – 0.13 = 57.74 and receiving a cash-flow yield of 0.13 from this option, so their “yield” is 0.13 / 57.74 = 0.225%. Since this option expires in 29 days, we can determine the annualized rate by solving for 0.225% / (29 / 365) = 2.83%.
For the “out of the money” option, the yield is (0.62 / (57.87 – 0.62)) / (29 / 365) = 13.63%. The yield curve is flat for the deep “out of the money” options and then gets steeper the closer strikes get to being at the money. Yields for options will get lower the further out of the money the option is. For retail investors writing covered calls, they may want to limit transaction costs by writing out of the money covered calls. Choosing a strike price will be related to the cash-flow yield generated and also the investor’s expectation on where the underlying might trade over the life of the option. Typically, retail investors employing this methodology will choose strike prices at the upper limit of where they expect the shares to trade while also generating an amount of cash that compensates them for transaction costs (such as their time/effort and brokerage fees).
This cashflow yield method can also be used for naked puts instead of covered calls by doing the same calculations, but in opposite directions. The risk for the investor writing a naked put is equal to the strike price minus the option premium. Say an investor is will to purchase shares of MSFT at 55.00 over the course of the next month when the share are trading at 57.87. An investor could write 1 month 55.00 puts at 0.59. The yield would be (0.59 / (55 – 0.59)) / (29 /365) = 13.65%.
An even easier way to determine the yield of these options is to take the time value divide by the underlying and annualize the rate. 0.59 / 55 * 12 = 12.87% Its a quicker way to compute a yield and most sophisticated investors can do this in their head or on the calculator on their phone.
There are more sophisticated ways to make these calculations using option greeks and other trading strategies that may yield better results, but like many strategies that work well for retail investors, the methodology describe here is easy to use and provides practical benefits. Its a rough and ready way to make decisions that help retail investors achieve their objectives, and I believe add a little bit of alpha to their portfolios.
