Theory isn't for everyone - especially when it comes to mathematical concepts. A good portion of us don't need to map out why 2+2=4. The only thing that matters is that it does.
For some volatility traders, the above means that options theory often gets left by the wayside. And rightly so, if that style fits your mindset, approach, and risk profile.
However, there are instances when a better understanding of theory can help us better execute our daily tasks as traders and risk managers. This point is illustrated quite clearly in a new set of research produced by the tastytrade team, and we think this information is well worth a few moments of your time.
In three new episodes on the tastytrade network, the primary focus is the theoretical value of an option, and in particular the unique way that every option's value can be broken down into two parts - intrinsic value and extrinsic value.
While these vocabulary words may not move you to the edge of your seat in terms of dramatic effect, the tastytrade team has outlined a method of utilizing these concepts in a way that may help you manage trade ideas and positions more optimally going forward.
As a brief reminder, the intrinsic value of an option is the value it would have if it expired immediately. For example, if you own the $45 strike call, and the underlying is trading for $50, then you know the intrinsic value of that option (assuming it expired right now) would be exactly $5.
Using the same example, the intrinsic value of the $40 strike put would be $0.00, assuming the option expired immediately and the stock was trading $50.
Stated in the simplest terms, the extrinsic value in an option is everything else - the value that isn't captured by intrinsic value. Extrinsic value is often referred to as "time value," because so much of it ties directly back to time.
Expanding on our first example, imagine that you own that $45 strike call, with the underlying trading exactly $50/share. If the current month is April, imagine how the value of that option changes if I told you that it expired in August versus December.
Obviously, a December $45 strike option would have greater extrinsic value than an August $45 strike option due to the uncertainty associated with the time in between. This value beyond the intrinsic value, is the time value of the option.
At this point, you might be asking yourself, "Ok, I understand the definitions, but how does that help me?" That's exactly where tastytrade has stepped in with an answer...
One key is to remember that intrinsic and extrinsic value behave differently depending on how in-the-money (ITM) or out-of-the-money (OTM) a given option is (or even at-the-money, ATM). And this dimension of the option's value may affect how you perceive a given opportunity, or how you manage the position after it goes live.
It's this exact line of thinking that was covered recently by The Skinny on Options: Abstract Applications team in a new episode titled "Managing By Extrinsic Value Drain," and the reason for its importance will soon be clear.
Now that we've established the definitions of intrinsic and extrinsic value, we can highlight a couple other important aspects of their behavior.
For example, at-the-money (ATM) and out-of-the-money (OTM) options are often 100% comprised of extrinsic value, while in-the-money (ITM) options will have more intrinsic value and less extrinsic value.
Peeling back another layer of the onion, tastytrade detailed how an options extrinsic value actually plays a big role in the type of trade management technique that has been historically most effective - based on whether an option is ATM, OTM, or ITM.
The two graphics below summarize the trade management techniques that typically correspond with OTM options (first slide) and ATM options (second slide):
As you can see in the above slides, the main difference between how we manage OTM options, versus ATM options, is that with the former we manage more loosely (allowing the position to work until 50% of maximum potential profit is received), and with the latter we manage more aggressively (attempting to close the trade prior to receiving 50% of the maximum potential profit).
Tying all of this together, the reasoning behind this trade management approach rests with extrinsic value - which is one reason that understanding this concept is so important.
With at-the-money (ATM) options, the extrinsic value in the option tends to cling to the position for a longer period of time. That's because ATM the money options can flip-flop between out-of-the-money and in-the-money as they approach expiration - meaning uncertainty can remain elevated.
On the other hand, out-of-the-money (OTM) options lose their extrinsic value more quickly. Theoretically, these options have less change of finishing with any value at all, which is what allows for that looser stance on trade management.
While you may have already had a solid grasp of the above concepts, the unique method by which the tastytrade team has connected extrinsic value with the various trade management techniques may help you when selecting or managing positions in the future.
If you want to further investigate these topics, we highly recommend reviewing the three episodes focusing on intrinsic and extrinsic value when your schedule allows:
If you have any questions on the topics covered in this blog post, don't hesitate to reach out with any questions by leaving a message in the space below, or sending us a message on Twitter (@tastytrade) or email (email@example.com).
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.