Extrinsic Value of an Option
Module 2: Option Value
Lesson 3: Extrinsic Value
The extrinsic value of an option is the dollar value that is placed on the remaining life of the option.
Similar to how the life insurance industry attaches a dollar figure to the estimated remaining years of your life. This dollar figure is what they use to create your insurance "premium".
It's slightly more complicated than that, but I think you get the point.
Well the time left until a stock option expires is given a dollar value and this is placed into the "premium" (cost) of the option along with the 5 other factors that we discussed in Lesson 1.
Extrinsic Value is also called time value. You will hear both terms used.
In the previous lessons we discussed that...
- There are six factors that effect the pricing of an option
- When a stock goes up: Call options gain value, and Put options lose value
- When a stock goes down: Put options gain value, and Call options lose value
- Selecting the strike price and expiration month are really the only two things that traders have control of (assuming you have already picked your stock)
- ITM, ATM, OTM are three terms used to describe the stock price to strike price relationship
- To keep things simple, new traders should pick the ATM option
Extrinsic Value and its Effect
on Option Pricing
Simply put, here is the effect that extrinsic value has on option price: generally, the longer the time until expiration, the greater the cost of the option. An option with more days left until expiration will cost more than an option with fewer days left until expiration.
An option with three months left until expiration has more time than an option that expires in two weeks. There is a greater chance the stock will move significantly over the span of three months then it will in two weeks. So you're essentially paying for that time.
Below is a snapshot of an option chain showing you how the cost of the option increases the further out in "time" (expiration month) you go:
The picture is of an IBM 95 Call Option. The strike price is $95. The arrows point to the cost of the February 95, March 95, April 95, and July 95 Call option.
What Happens if the Stock
Doesn't Move?
Suppose you buy an option with 3 months left until expiration. You have paid for 3 months of extrinsic value, or 3 months worth of time. If the stock doesn't move for a month and stays at the same price, then the value of your option will be worth less then when you bought it (it will decrease in value).
This is because the time value (extrinsic value) has been ticking away. You now have only two months of value left in the options price. This is called: time decay. This is also why options are often called wasting assets, and is part of what makes them risky.
With stocks you can hold onto them forever waiting for them to move in the desired direction. With options, the moment you buy them the clock starts ticking away. The stock "must" move, or you will start losing money.
Intrinsic vs. Extrinsic Value
As we have already discussed, part of the option's price is determined by how much time is left until it expires, and how much value it holds to someone who wants to exercise the option. If you pick an option that is out-of-the-money (OTM) then it has no value to anyone.
Exercising an OTM option would put you at a loss so the only value it has is extrinsic value (time value).
**Quick ITM Recap**
The in-the-money (ITM) options have value because they allow you to either purchase the stock at a discount (in the case of a Call option), or sell the stock at a high price (in the case of a Put option). This value is called intrinsic value.
Because of time decay (extrinsic value fading away) you need something to offset the loss in value. You don't want to pay for too much time, but you do need enough time for the stock to move so your option can become ITM.
Once an option moves to ITM, then it will start gaining value rapidly and the effect of time decay will be negligible because intrinsic value will take over. This is why I suggest new traders pick the at-the-money (ATM) option.
As a trader you have to be disciplined and thorough in your research. You want to pick the best stocks poised to make a move in a relatively short period of time.
How Much Time Should You Buy?
The further out in time you go the more the option will cost you. Most new traders think that it's best to save money and pick what they call a front month option. This is an option with a few weeks up to a month left until expiration. WRONG APPROACH!
Things will go wrong, deal with it! The way to deal with it is to err on the side of caution. Pick an option that gives you enough time in case things do go wrong.
Remember options are wasting assets. If you pick an option with a month left until expiration, it doesn't give you much time for things to pan out. Besides that, depending on the option you pick the time decay dramatically increases the last 30 days of the options life. It will lose value at an accelerated rate.
There is however, a strategy where picking front month options is the way to go, but in my opinion that strategy is too advanced for beginners. Not because of its complexity, but because they don't fully understand how all 6 factors affect the option's value.
If you have a choice between cost and time, I'd pick time. Extrinsic Value can be expensive though, so select a stock that has options you can afford. There are plenty out there. You will learn how to do all of that later in this course.
Extrinsic Value Trading Rule
Inexperienced traders will buy an option that has 3 months left until expiration and two months later they are holding onto their position thinking "I have a whole month left until expiration so I'm going to hold on to it to see if I can squeeze more money out of my position."
Then the stock moves in the desired direction and the option begins to lose value and they don't know why. This happens because the extrinsic or time value decay rapidly increases the last 30 days of an options life. So until you become more experienced in this subject follow this rule:
Sell your option positions 30 days before they expire. If you have a December 30 Call option, sell or close out our position the 3rd week of November.
Until you are very experienced with options trading and understanding all the factors that effect pricing, this rule will protect you from your lack of knowledge.
Since this rule is a MUST, you have to add 1 month to whatever time frame you plan on staying in the trade.
For example, you pick a stock and your research tells you that this stock stays in a steady trend for at least 3 months at a time. In this case, you want to buy an option that gives you 4 months worth of time (3 for the trade and 1 to satisfy the rule).
If you merely buy an option that has 3 months left until expiration then you'll hit your 30 day rule 2 months into the position and you'll have to exit the trade (close out your position).
That's it for this lesson. I prefer to keep things simple for you on this subject. Once the "Further Learning" sections of the website are developed I will go more in detail on intrinsic and extrinsic value. This section was to give you a basic working knowledge of extrinsic value and how to maneuver your way around its effects.
Lesson Review
The farther out you go with the options expiration month the higher the cost will be.
The extrinsic value portion of the options price dwindles down on a daily basis.
Once an option moves to ITM, then it will start gaining value rapidly and the effect of time decay will be negligible because intrinsic value will take over.
Sell your option positions 30 days before they expire.
Now that you have a basic understanding of extrinsic value proceed to Proceed to Lesson 4: "Option Volatility".
Module Instructions: According to how the site is set up, you are now in Module 2: Lesson 3 (Extrinsic Value). For the most effective learning experience, read through each lesson in this module one by one, in the exact same order as they are listed in the table of contents to the left.
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