Alpha (α): difference resulting from subtracting your return from the benchmark return, aka: excess return. This can be the excess return of a portfolio versus index, stock versus portfolio, stock versus index, etc., etc, etc. Since our strategy is selling calls to add additional income or return, the selling of calls is our attempt to add Alpha. Alpha can be positive or negative. Example: If the S&P 500 return was 10.0% and your portfolio returned 11.0% your alpha would be 1.0%. If the market return was 10.0% and your portfolio return was 9.0% your alpha would be -1.0%. The time comparison period or horizon used is typically 1 year. In our world of selling calls, the time period may be limited to how long we perform the strategy. Caterpillar (CAT) has been in our portfolio for a while. We acquired it because it fit our profile of big dividends, low P/E and options that offered attractive income. By owing CAT we received the dividends and the benefit of any stock price increase or decline. Selling calls against the stock adds additional income that enhances the overall return. If the stock is called, we are limited to the amount of benefits we receive (options premium, price appreciation to strike, and possible dividend). We can always buy the stock back and hold it or try to enhance the returns by selling calls. If the stock is not called we reduce the cost basis by the premium received and move on. As long as we are active in the stock we are developing our horizon for measurement.
Beta (β): a measure of how a stock’s movement correlates to the movement of the entire stock market.(1) The beauty here is that you get to define “the entire stock market”. Let’s face it, the “entire stock market” is pretty big. Moreover, you really are not interested in most of the stocks in it. So it is pretty commonplace to use indices as proxy’s for the “entire stock market”. We all know the biggies, Dow, S&P 500, NASDQ. However, there are dozens if not hundreds of market indices out there. If you want you can make up your own. Why not? The proliferation of market indices follows the specialization of funds management. It makes sense as a growth style manager and a value style manager should have different returns given the distinctly different nature of the stocks they should be buying. Generally speaking, neither one would have generic market returns. Dividend or income managers should also have a different return. The Investment Consultant industry have done a very good job in proliferating indices. How use full is all this? As my old stats professor used to ask, “How many angels can you fit on the head of a pin?” In other words, who cares if the returns do not meet your needs?
Break-Even Point: the stock price (or prices) at which a particular strategy neither makes nor loses money. It generally pertains to the result at the expiration date of the options involved in the strategy.(2)
Delta (Δ): 1) the amount by which an option’s price will change for a corresponding one point change in price by the underlying entity…, 2) the percent probability of a call being in-the-money at expiration.(3) We do not implicitly use delta. It is a fancy guess and like every thing else has too many variables affecting it. But is a useful number. Every time we look to write an option, we make a quick mental calculation or guess as to the probability of the call actually being executed. We gauge our reaction toward the stock being called away. For example, the ex-dividend date is 30 days from today. The first options expiration date is 20 days away. If we want to make sure we receive the dividend among the things we can do are buy the stock and: 1) avoid writing (selling) options all together until we get past the ex date, 2) write options way out of the money (low delta) for the next expiration date about 50 days away, 3) write near dated options (low or high delta) and if called re-establish our position so we are holding the stock on ex date. Struggling with which decision to make is not uncommon. After all we are trying to optimize income on each position. If options premiums are high or rich, it is a problem. Because the markets are liquid we can always re-establish a position but that requires an effort and potential missed opportunity.
Expiration Date: the day on which an options contract becomes void. The expiration date for listed stock options is the Saturday after the third Friday of the expiration month. All holders of options must indicate their desire to exercise, if they wish to do so, by this date.(4)
Implied Volatility: a measure of the volatility of the underlying stock, it is determined by using prices currently existing in the market at the time, rather than historical data on the price changes of the underlying stock.(5)
Intrinsic Value: the value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the stock price and the strike price, if that difference is a positive number, or zero otherwise.(6)
Premium: for options, the total price of the option contract. The sum of the intrinsic value ant the time value premium.(7)
Relative Value Index (RVI): the percent of the spot price or evaluation price to a price range. If the 52 week price range of a stock is $10.00 - $20.00 and the spot price is $15.00 the RVI is 50, for a price of $17.50 the RVI is 75 and for a price of $12.50 the RVI would be 25.
Rich/Cheap: Expensive/Bargain….. this is value and is sometimes real and sometimes perceived. As with beauty, value is in the eye of the beholder. I have known people who are appalled at the price of things when someone else is selling them but insulted if you value the same asset in their possession at the same price. The classic car you buy is cheap/bargain when you get for substantially less than Hemmings Motor News estimated the price. It becomes rich/expensive when the head blows, the muffler falls off and the transmission fails. With options, we like to sell when they are priced rich and buy when they are cheap.
Spot Price: current market quoted price of the stock, option, etc.
Stand Still Return (SSR): the percent return based on intrinsic value. The premium earned on the sale of the option divided by the spot price of the stock.
Time Value Premium: the amount by which an option’s total premium exceeds its intrinsic value.(8)
Volatility: a measure of the amount by which an underlying security is expected to fluctuate in a given period of time. Generally measured by the annual standard deviation of the daily price changes in the security, volatility is not equal to the Beta of the stock.(9)
1 Options AS A STRATEGIC INVESTMENT, 3rd Edition, 1993, Lawrence G. McMillan, New York Institute of Finance Corp, Simon & Schuster, page 854
2 Options AS A STRATEGIC INVESTMENT, idid, pg 854
3 Options AS A STRATEGIC INVESTMENT, ibid, pg 857
4 Options AS A STRATEGIC INVESTMENT, ibid, pg 860
5 Options AS A STRATEGIC INVESTMENT, ibid, pg 861
6 Options AS A STRATEGIC INVESTMENT, ibid, pg 862
7 Options AS A STRATEGIC INVESTMENT, ibid, pg 865
8 Options AS A STRATEGIC INVESTMENT, ibid, pg 870
9 Options AS A STRATEGIC INVESTMENT, ibid, pg 871
