Understanding extrinsic value in options trading - Brown Surfing

Understanding extrinsic value in options trading

Posted on: November 8th, 2022
By: Efrain Lemus

Extrinsic value = option premium – intrinsic value

If implied volatility increases, extrinsic value increases.

A contract loses value as it approaches its expiration date.

Intrinsic value is the money you can make if the contract is exercised right now.

If a stock is trading at $55 and you buy the $50 strike price, you have $5 of intrinsic value.

A put option has intrinsic value when the underlying price is below the strike price.

A call option has intrinsic value when the underlying price is above the strike price.

Option prices are based on three elements:

Time to expiration

Just like insurance, options have expiration and you have to buy every certain period of time.

More time equals more money. As time passes, an option’s value will decay.

Time decay isn’t linear, it’s exponential.

An option’s time value is always decaying 100% of the time.

Underlying stock price

Strike price: predetermined price at which the shares of stock will be exchanged if the option is exercised.

For calls any option that a strike price above the underlying price is out of the money If the strike price is below the underlying price is in the money.

For puts, if the strike price is above the underlying price, it’s in the money. If the strike price is below the underlying price, it’s out of the money.

Worthless at expiration means out of the money.

You do not have to hold the contract until expiration. If you buy a call option today with 30 days to expiration, and the stock goes up overnight and the call option is now worth $200 more now than when you bought it, you can sell it for a profit.

Expiring worthless means, the contract is worth nothing at expiration. Do I want it to expire worthless?

Time value equals extrinsic value.

Volatility

Volatility is the magnitude of a stock’s price swings. Volatility equals more risk for stock holder. Options are worth more when there is more risk.

Different stocks have different volatility.

Volatility is predictable (mentioned in the book The Quants).

Option price equals intrinsic value plus extrinsic value.

Extrinsic value equals option price – (underlying price – strike price)

Why worry about extrinsic value?

As expiration approaches, extrinsic value diminishes.

Keypoints

When you sell a contract, you want to buy it back for less than what you paid for.

p.s. options are insurance for investors

Questions

  • Do I want to enter positions with a high extrinsic value?
  • Do I want my contracts to expire worthless?
  • Why worry about extrinsic value?
  • Do I want to buy/sell puts/calls that only have extrinsic value?
  • Do I want to buy calls/puts if the extrinsic value will only diminish?
  • how options decay extrinsic value vs intrinsic value
  • How does Vega and Theta play a part in extrinsic value and how to use it to make better decisions?

Have any questions or comments? Write them below!


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