With the variables in play, the usual method of assigning a percentage to premium is far from accurate. For example, an option’s current premium is 4 ($400) and the price of the underlying is $95 per share. A popular method of calculating yield is:
4 ÷ 95 = 4.2%
Is this accurate? It is if comparisons between several options are made with the same moneyness and time to expiration. But comparisons usually involve variations of these, so the popular method of arriving at yield is practically useless. In fact, when you study the range of possible variables, you discover there is much more to it than a simple division of premium by underlying. The possible variables:
- Moneyness of the option, with farther in or out of the money distorting the yield.
- Time remaining to expiration, re cognizing the acceleration in time decay and how that affects expectations of yield.
- Long versus short positions, in the sense that rapid time decay and short time to expiration are advantages on the short side but have greater impact on yield.
- Spread between bid and ask, and which value is used in the calculation. (Many models use the average or center of the spread, but this is entirely inaccurate. The greater the spread, the more the potential distortion of yield. It makes sense to use either bid or ask, depending on whether the proposed position will be short or long.)
- Dividends, remembering that offering a dividend adds to overall potential yield, and that the closer to ex-dividend date, the greater the annualized effect of that payment will be on yield.
- Price of the underlying versus premium of the option. In other words, comparing a $30 stock to a $300 stock is inaccurate unless the relative premium of the option is approximately the same (10 times more premium for options on stocks valued at 10 times more per share, for example). This exact relationship does not exist in every case, and often leads to further distortions.
Why is this important? When you think about the various strategies used by traders, a distorted view of yield can have great impact on judgment and selection of the most advantageous or lowest-risk option and stock to pick. For example, a simple but popular strategy is to sell puts with a comfortable buffer zone between strike and current price. This can be based on an assumed number of points combined with time to expiration, or with the use of indicators like Bollinger Bands. The greater the band width, the more management the risk, or so the assumption claims.
For higher-priced stocks, a wide bandwidth appears to add great safety to the short put. Having 30 or 40 points of buffer zone and with only a few days to expiration, the trader has a sense of security. But with current high volatility ibn the markets, is this as safe as it seems? If earnings or ex-dividend date will arrive before option expiration, the risk is only enhanced and what appears an attractive yield could end up a disaster.
Even without earnings surprises, however, the number of buffer points is not an accurate test of yield or risk. Referring again to Bollinger, the default of two standard deviations from upper or lower bands to the center line is a good starting point. The wider the deviation (thus, greater the volatility in the underlying), the higher the buffer points achieved. But at the same time, that volatility translates to much greater overall risk. A system for making the bandwidth more accurately reflect risk and yield takes a few steps:
- Calculate total bandwidth from upper and lower bands, and then divide this bandwidth in half.
- Apply this distance to current underlying price to arrive at a realistic range of buffer prices. Add to current price to get the highest price and subtract from current price to get the lowest buffer price. The distance between these two buffer prices gives you an approximate risk range. For the short put strategy, this gels narrow down the yield as well as potential range of risk. Of course, the true risk involved also relies on how much time remains until expiration.
This method is more reliable than an alternative used by many short put traders. They just review a series of strikes in comparison to current underlying price, looking for an attractive dollar value to open. But the true risk relies on all the other volatility factors, timing, and historical volatility. Just seeking an attractive price with what seems like a great buffer zone is not a safe or accurate way to pick short puts … or to move into other strategies with similar risk elements and variables.
Even this more analytical method for calculating relative yield is admittedly random and arbitrary to some degree. But it gives you a better sense of the risks involved in picking a strategy. Any method used to select strikes and positions is going to contain random variables, but the key difference is to apply some consistent science to how it is done. Therefore, indicators like Bollinger Bands may offer somewhat better control over risks, whereas those same risks often are invisible using other methods like simple division of premium by price.
Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook.