Maximizing Annualized Option Yields Charles J. Higgins, Ph.D. Dept. of Finance/CIS Loyola Marymount University 1 LMU Dr.

Los Angeles, CA 90045-8385 310 338 7344 chiggins@lmu.edu

April 2, 2011 7th draft; not for attribution without permission

Abstract: Option prices rise with time to expiration. Out-of-the money options have the greatest annualized prices with expirations of one year for strike/exercises beyond the underlying security price approximately equaling one-half the annual standard deviation of the underlying security. For in-the-money and at-the-money options the shortest expirations have the greatest annualized prices.

Maximizing Annualized Option Yields A call option is the right to purchase a security at a specified exercise (strike) price, and has a theoretic value of: 1a) 1b) Pt = St X, if St > X, or Pt = 0, if St <= X

where Pt is the value of the option at time t, St is the value of the security at time t and X is the exercise (strike) price. The expected prices of in-the-money call options (S > X), and an atthe-money call option (S = X) rise at a decreasing rate as t increases with greater time to option expiration. However an out-of-the-money call option can rise at an increasing rate in the earlier portion of the options life.

Fig. 1

This graphic was created with a simulated security price of So = 100, a daily standard deviation of .02, and a price at time t of St = St-1 (1 + ) where is a random standard normal distribution from = (-2 log(1) sin(2)) where 1 and 2 are independently chosen random uniformly distributed from 0 to 1; thus is N(0,.02) with a mean of zero. Whether should have a mean of zero is relevant; the mean daily return of zero is considered here (the daily mean return of the market is roughly .12/252 or about .000475). The price ranged to 12 across some 256 simulated trading days. The out-of-the-money options may exhibit an increasing then decreasing rate of price increases as the options increase in time to expiration. The highest annualized yield for a call option writer (seller) would have the highest tangent slope to the origin:

Fig. 2

An out-of-the-money call option writer seeking to maximizing annualized yields of Pt / t would, for a security priced at 100 with a daily standard deviation of .02 (about .32 per annum with the standard deviation increasing as a square root of time) or here 2 points, would prefer: for a call option with a strike price 5 points higher an expiration about a month away, for a call option with a strike price 10 points higher an expiration about three months away, for a call option with a strike price 15 points higher an expiration some six months away, and for a call option with a strike price 20 points higher an expiration some nine months away. Or:

Fig. 3

Likewise, similar expiration dates would apply to a security price of say 50 with strike prices of 2.5, 5, 7.5, and 10 respectively higher if the daily standard deviation remains at 2 percent (or now here 1 point). In the case of an increase in the standard deviation, it would move the highest annualized option yield expiration dates somewhat sooner, or:

Fig. 4

In the case of a decrease in the standard deviation, it would move the highest annualized option yield expiration dates substantially later and especially so for those options which are farther out of the money, or:

Fig. 5