The importance of option Extrinsic and intrinsic value in options trading.

in #options-premium2 years ago (edited)

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An important concept to understand in options trading is the concept of an Options value, as defined by it’s intrinsic and extrinsic value because these definitions and their synonyms are frequently used to explain a trading strategy or more importantly the explain why a trade went against you. While options trading is mathematical and logical, humans have a tendency to use slang terms and to use terms with very specific meanings as synonyms for similar but not synonymous situations. This imprecise term usage makes learning options difficult for the beginner, but it is an existential phenomenon, so there is no choice but to learn not only the terms precise meaning, but also their synonyms and synonymous usage. So with these thoughts in mind, let’s review.

Option Price

The price paid to acquire the option, which is also known as option premium. There are two components to the options premium and they are intrinsic value and time value.

Intrinsic Value
The intrinsic value is determined by the difference between the current trading price and the strike price.

Examples;
Call options with strike prices below the market have intrinsic value and put options above the market price have intrinsic value.
Thus you can see that only “in-the-money” options have intrinsic value.
Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price.
The converse of the above is that: “out-of-the-money” options have no intrinsic value. Call options which are above the market price and put options which are below the market price are “out of the money” and have no intrinsic value. They therefore have only “extrinsic or time value’.

Extrinsic Value also called Time Value
An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. This is also called “Theta decay**. As such, options are also called “wasting assets”. The term wasting here means a loss of or reduction of Extrinsic or Time value with the passage of time. For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. For out-of-the-money options, since there is zero intrinsic value, time value = option price.

Observations;
Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.

As you can see there are many synonyms here.
Time value and Extrinsic value. Also option traders use Time Decay and Theta Decay as synonyms to describe the same “wasting away” of the options price due to the passage of time. Additionally, options traders will sometimes use the term “ in-the-money” as an synonym for “intrinsic value” and conversely the term “out-of-the-money” as a synonym for “extrinsic or time value”. As you can see these are not true synonyms, but in options trading slang, they are sometimes used interchangeably.

As an example of the importance of this understanding is a this: Many discussions of the effect of “Theta” or time decay often state that Theta causes rapid reduction in the value of out-of-the-money options positions, so buyers of these options consider Time or Theta to be their enemy as it devalues their purchases to zero over time. Because buyers of options hope to buy low and sell high, after a favorable move in the stock price towards their positions strike price. But in the absence of such a move the value of those options drops every day and accelerates also every day. This is in contradistinction to sellers of these same out-of-the-money options. Whose strategy is to sell high and buy back low or simply let the Option expire, so they can keep all the premium or price they were paid for it by the buyer. So to sellers of these same out-of-the-money options Theta or Time decay is their “friend”.

An additional synonym type usage you need to understand is the reference of Theta decay being good for high probability spreads. In this instance the term “high probability spreads” refers to “out-of-the-money options” because “out-of-the-money options” tend to be far from the market price and the further the predicted price is from the current price, the lower the probability the stock will close on that price. So for sellers of these options who are relying on the stock not reaching that price to profit, these “out-of-the-money options” trades are considered to have a high probability of success. But you now understand that these “out-of-the-money options” have no intrinsic value and only time value, so in discussions the terms high probability trade and high or only extrinsic/time value are used as synonyms in the context of the discussion.

Now, I want you to pause and realize that this idea of high probability trading is based on the low probability of the stock price making large moves in short periods of time, thus if you are betting the stock won’t reach a certain price you will be right most of the time and there is a high probability you will make money. Let’s look at the numbers so this is clear.

Apple stock price 100.00
Option expiration date 30 days into the future
Options strike price of 14.0
Option premium is 2.00
The premium of 2.00 for the strike price of 140 is 2 Standard deviations from the current market price. This option is out-of-the-money and is an option with no intrinsic value and all time or extrinsic value.

We can also state mathematically that a strike price 2 standard deviations away from the market price is in the 95th percentile, or there is a 95% chance that the stock will close at a price below this in 30 days. There is however a 5% chance the stock will close above this price of 140 in 30 days.

But as this option ages, every day it loses time to expiration and every day it loses value.
The option premium was 2.0 at 30 days to expiration.
The option price will be 1.0 at 15 days to expiration. The option has lost time and value.
Theta measures the rate of option value decline, and the rate of decline is the decay rate.

Note: The rate of option price decline is not uniform because the decline rate accelerates as the Option ages. Thus Theta gets greater as the Option ages.
Example:
The option drops from 2.0 to 1.6 in the first 9 days, but then from 1.6 to 1.0 in the next 6 days, as the decay rate accelerates.

These concepts of high probability, Extrinsic value, time or Theta decay and the acceleration of decay as the Options age are core concepts for understanding and profiting from options. Please see my other posts on options Theta for further explanation.

✍🏼 By Shortsegments.

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Title: The importance of option Extrinsic and intrinsic value in options trading.

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