When trading volatility it’s easy to become preoccupied with the VIX, market trends, and news flow. While these are critical components of effective analysis, we can’t forget the basic building blocks of options trading.
According to the infamous Black-Scholes model, there are two important values that together represent the market value of an option - intrinsic and extrinsic value.
The intrinsic value of an in-the-money (ITM) option is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero. For example, the $15 strike call of a stock trading $20 will have an intrinsic value of $5 ($20-$15 = $5). And the $25 strike call of a stock trading $20 will have an intrinsic value of $0 (at expiration).
Extrinsic is the term used for the value of an option beyond its intrinsic value. Demand in the market dictates the “premium” that traders are willing to pay - which dictates extrinsic value. Going back to the previous example, a $25 strike call trading for $0.25 with stock trading $20 and one hour until expiration will have an extrinsic value of $0.25 (because there is no intrinsic value left in this option).
Similarly, a $15 strike call worth $6 with the stock trading $20 and two weeks until expiration will have an intrinsic value of $5 and an extrinsic value of $1.
Extrinsic value is implied by the market because of the 5 inputs used to calculate the price of an option using the Black-Scholes model, the extrinsic value (implied volatility) is the only unknown. Plugging the four known factors into the equation therefore allows us to solve for the unknown.
This is the primary reason that the fair market value when trading is referred to as “implied volatility.”
A recent episode of Best Practices takes a close look at “extrinsic value” and provides a 360-degree perspective on the topic.
As noted in the episode, extrinsic value rises and falls based on demand for protection in the marketplace - option prices get more expensive (i.e. extrinsic values go up) when “fear” increases.
The generally inverse relationship between the S&P 500 and the VIX provides reinforcement of this pattern – when the S&P 500 is falling (fear is rising), the VIX tends to increase.
As you can see in the next graphic (shown below), the extrinsic value of the at-the-money (ATM) straddle in Apple (AAPL) was much higher when the market was dropping, as compared to now:
Taking these learnings a step further, it shouldn’t be surprising to learn that implied volatility will generally be higher for the options of high-flying stocks as compared to Blue Chips.
The chart below provides stark evidence of this phenomenon by comparing the implied volatilities of Coca-Cola (KO), General Electric (GE), Apple (AAPL), and Tesla (TSLA):
Going out in time, extrinsic value generally increases due to the vega component of the options price. Obviously, the further one goes out in time, the more difficult it is to forecast a stock’s price – thus the added premium found in extrinsic value.
While the VIX and Implied Volatility Rank (IVR) can help guide overall portfolio structure, extrinsic value is another factor that can be evaluated when deploying and managing a volatility-based strategy.
If you have any questions about extrinsic value we hope you’ll reach out at email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.