Tales of a Technician: The Preeminence of Extrinsic Value in Covered Call Management
August 3, 2020
Last update: August 2021
When it comes to covered call management, everything revolves around extrinsic value. If you know what it is and how to track it, then you will be able to make an informed decision at every step in your trade.
A Primer
An option’s premium or cost is comprised of intrinsic value & extrinsic value. Intrinsic value is how much in-the-money the option is. Extrinsic value is how much you pay for time and volatility. Here’s the Key Formula:
Premium = Intrinsic Value + Extrinsic Value
Some traders refer to extrinsic value as “time value.” Though, as I’ve said before, I think emphasizing time over volatility is misguided. At any rate, extrinsic value is the chunk of an option’s value that is susceptible to time decay.
Saying that an option’s premium falls over time is correct. But it’s not the most accurate way to explain what’s happening because the intrinsic value portion of the premium is immune to time decay. Thus, we should say, an option’s extrinsic value falls over time, ultimately reaching zero at expiration.
You’ve probably already heard that extrinsic value is highest for long-term options. What’s less known is that extrinsic value changes as you move from strike to strike. It peaks with ATM options and dwindles as you move further OTM or deeper ITM.
If you want to know how much profit you have remaining in the short call portion of a covered call position, don’t look at the call premium – look at the call’s extrinsic value.
Sure, sometimes both numbers are the same. But not always. For example, when the call is OTM, its premium equals the extrinsic value. When it’s ITM, however, its premium does not equal the extrinsic value.
An example will illustrate. In the options chain above, suppose we already owned 100 shares of stock and sold the first strike OTM, the $440 strike for $12.52. Our potential profit due to time decay would be the entire $12.52 because it’s all extrinsic value.
Now, let’s say instead, we sold the $420 ITM strike for $22.75. Is our potential profit due to time decay the premium of $22.75? No! It’s only the extrinsic value of $7.20.
Enter Trade Management
Let’s talk about how focusing on extrinsic value can simplify covered call trade management. It provides an easy answer to a multitude of questions. Here are three common questions:
- When do I take profits on my short call?
- When do I roll my short call?
- When should I close the call to avoid assignment?
The answer to all three queries lies with extrinsic value. Here is the rule:
Buyback your short calls when there is little to no extrinsic value remaining. You can decide if “little to no” means 5 cents or 10 cents or 15 cents, but the bottom line is this: When the extrinsic value runs to zero, you can’t make any more profit due to time decay. Thus, you should exit or adjust the trade to keep the dream alive.
In other words, it doesn’t do me much good to sit in a covered call that’s already run out of time value. There’s no further profit to be made.
In the instance of worrying about early assignment if your call moves ITM before expiration, it is, again, all about the extrinsic value. If there’s still a modest amount remaining, you won’t be assigned early. So my rule of thumb is to let the covered call ride (whether ITM or OTM) until the extrinsic value approaches zero.
Exceptions
The one exception to this rule is if my directional outlook on the stock shifts, and I want to rapidly modify my position more bullish or bearish. Consider a stock that’s breaking out of a major resistance level. By all measures, it looks like it’s going to blast off, but you have an ATM covered call capping your gains. Do you leave it be, reasoning that there’s still 50 cents of extrinsic value? Or, do you roll it up to open additional profit potential in the stock? This tactic would more fully take advantage of a big rally.
Or, suppose the stock is falling dramatically. Do you hang onto your now far OTM call simply because it still has 25 cents of extrinsic value remaining? Or, do you roll it down to a lower strike to increase the amount of premium (and thus protection)?
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Thank you Tyler
Tyler – Excellent article for me as a beginner learning to manage covered calls!