Show notes
Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to continue our discussion from yesterday and talk about option extrinsic value explained. In yesterday's podcast, show number 492, we described what intrinsic value was for an option price. Now, it seems only fitting that we describe what the extrinsic value component of an option's price is. Again, remember that an option's price is mainly comprised of two different components, two different broad category components. The first is intrinsic value which is just the value should it be exercised right now which we discussed yesterday in show number 492. Today, we're going to be talking about the other component which is extrinsic value. Extrinsic value is mainly comprised of time decay and volatility value in the contract. It's just a fancy way of saying – How much value is in the contract because of how much time is left until expiration or how much value is in the contract because the stock might be more volatile than not based on the time left until expiration. This is where people get confused sometimes on option pricing because they see option pricing and they understand the intrinsic value component which is very easy to calculate, but now, there's this additional component which is this time or volatility value. But remember, all things being considered, if there's more time until expiration than not, then that leads to higher option prices. When you enter into an option contract and you have a year until expiration, well, that's more valuable than if you were to enter into an option contract and there's a day until expiration. Not much can happen in a day, but a lot can happen in a year. The same thing can be told about implied volatility as you go further out in time. If you enter into an option contract and the underlying stock is very volatile and has huge moves up and down, say 10% or 20% in either direction, well, that's more valuable because now, the stock could seemingly swing into a profitable zone. There's a huge volatility or expectation of volatility in the option, so now, that's more valuable to the option buyer. When you have a stock that has low volatility, maybe that doesn't swing more than .5% per day on a further extreme end of the spectrum, then that's less valuable to an option buyer because they know that the stock is not going to have these huge swings, so they're not going to bid up the value of that option contract hoping for a big profit because the likelihood is that the stock is not going to make a big move. This is where we see these two components now start to evolve and be folded into option pricing over time and they change and adapt as new information comes out about the company, as trader's expectations change and as we compress time until expiration. Now, the extrinsic value component of time decay is relatively standardized. It means that we don't have any increasing number of days and usually, days start ticking off one by one. We don't tick off days two days and then three days at a time. The time value component of an option contract is fairly standardized in the sense that we know how quickly on average different days until expirations will lead to different decays in the option contract.
The one volatility factor that's a little bit different is implied volatility. And so, the expectation of high volatility or low volatility changes on a daily basis based on how active people are buying or selling the option contracts. And so, this one component of extrinsic value is really the one that fluctuates the most and can lead option prices to be at further ends of the extreme spectrum very quickly even though a lot of other things didn't change like the stock price or the time until expiration. When you look at an option price, for example, let's say that we're trading a 100 strike long call option and the stock price is trading at $105. Well, that 100 strike long call option as we discussed yesterday in the podcast, show number 492, has $5 of intrinsic value. The 100 strike long call option when the stock is trading at $5 has to be at least priced around $5. That's the intrinsic value. That's the raw value should the contract be assigned right now. But if we look at the option pricing table and we see that that option contract is actually priced at $7, we know that $2 of that option's price now can be associated to the extrinsic value of the contract. We know $5 is associated to the intrinsic value, the value derived right now should you exercise the contract. That extra $2 of premium that we see if the option contract is trading for $7 can now be associated to extrinsic value, the time in volatility value of that contract still in the open market. This may be a contract that's 30 days from expiration. Now, we look at a 100 strike call option that's 90 days from expiration and we see that the value or price of that option contract is say $10. Well, now we know that again, $5 is associated to the intrinsic value and $5 is associated to this extrinsic value and intuitively, that makes sense that we have now more time until expiration, so that's more valuable potentially and we have a greater time that the stock can make these huge volatility moves that again, potentially is more valuable. This is where you see these components start to be dissected and compressed as you're looking at option pricing. Now, does this mean that you always need to look at extrinsic and intrinsic value? No. But you should have a good understanding of what components are folded into an option's price and understanding that there's an intrinsic component and an extrinsic component made up of value for time decay and volatility really helps you when you get into certain situations as a trader and understanding potentially if you're at risk of assignment or not or how fast the option contract is going to decay in value, how much more room there is to profit in an option contract if you're an option seller especially when you get into the week of expiration. Hopefully this helps out in kind of understanding these broad categories. I know we can't go through everything on this podcast, but hopefully kind of ticking off these broad categories again, helps out tremendously. As always, if you have any questions, please let me know and until next time, happy trading.
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