Last Update: July 2021
I’m the anti-handyman. Just ask my wife. Fixing stuff in the house intimidates me. Could I figure it out? Sure I could, but when you don’t know what you’re doing things take forever. I’d rather bust out an article or throw on a trade or teach a class and then pay someone else to fix the dishwasher.
It’s a no-brainer.
For those of us unwilling to outsource our investments, however, we must of necessity figure things out ourselves. I remember when I first started trading it took forever to find a trade and enter the order. Then I’d have to remind myself of my trading plan each day as I tried to remember how the heck I was supposed to manage the trade.
Now, my big brain is friggin’ computer and my plan comes to mind a microsecond after I seek it out. See, I got tricks. Lots of them. All sorts of mental shortcuts to save time so I can go play with my kids. I’ve already shared a few (see here and here) and today I’ll unveil another of particular interest to option sellers.
First, a brief review of option pricing is in order. An option’s premium is comprised of two components: intrinsic value and extrinsic value. Intrinsic value is a function of how deep in-the-money an option sits and is the part of an option’s premium that is immune to time decay. The only variable that affects the amount of intrinsic value is movement in the underlying stock price.
Extrinsic value, or time value, is a function of time to expiration and the expected volatility in the stock between now and then. Extrinsic value is the portion of an option’s premium Father Time whittles away at day-by-day.
When you sell an option with the intent of generating cash flow you are trying to capture the extrinsic value in the option. Once the extrinsic value bleeds out the additional passage of time won’t improve your profit at all. This is why it’s so important to be able to calculate extrinsic value for short option positions – covered calls, short puts, credit spreads, and so forth.
If you want to calculate the amount of extrinsic value in an option you can always do it in your head. Simply subtract the intrinsic value from the premium. For example, say you’re short the 50 call on a $52 stock and the call is currently worth $3. How much extrinsic value is left in the call?
$1. Simply subtract $2 of intrinsic value from the $3 premium.
Of course, you could also display extrinsic value as a column heading in your option chain, but where’s the fun in that? More numbers to look at? Boo!
For those looking to simply their lives allow me to introduce the extrinsic value trick.
The amount of extrinsic value of the same strike call and put (in the same month) is virtually identical. So, if you’re short a put that’s now in-the-money and you’re wondering how much extrinsic value is left simply look at the value of the same strike call. Since the corresponding call is out-of-the-money its premium is its extrinsic value.
Let me to illustrate with the January options for AAPL. Let’s assume with AAPL around $115.50 or so you’re short the Jan 120 ITM put and want to know how much extrinsic value is remaining. In graphic 1 below I show the extrinsic value column which reveals there is about $1.74 in the option.
Now, suppose you don’t have the extrinsic value column and want to utilize the trick instead. Consider graphic 2. Though the extrinsic value for the puts isn’t being displayed I could simply look across the option chain to the value of the Jan 120 call. It’s worth around $1.79 which reveals about how much extrinsic value is remaining in my short Jan 120 put. Got it?
Now, let’s look at an example with a short in-the-money call. Let’s say you’re short the Jan 110 call as part of a covered call position. With the short call now sitting a fair amount in-the-money you want to determine how much extrinsic value is remaining to know if there’s more money to be had in the coming days. I could plot it as a column heading like shown in graphic 3:
Or, to identify the roughly $1.78 of extrinsic value I could use the shortcut and simply look across the chain to the corresponding out-of-the-money Jan 110 put which is worth about $1.73. That tips me off that there yet remains around $173 of time value remaining in my Jan 110 covered call so I would remain in the position to collect yet more cash flow between now and January expiration.
Be forewarned there will be situations when dividends are being paid out in the stock between now and expiration where the value of the same strike call and put is quite different. But, once adjusted for the dividend the trick should hold true.
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4 Replies to “Tales of a Technician: The Extrinsic Value Trick”
Is this true for OTM options as well
Morning James! You don’t need any trickery for finding the extrinsic value of OTM options. See, the premium of an OTM option IS the extrinsic value. So it be staring you right in the face:)
Neat Trick. While we are on the subject of extrinsic value and shorting options, one does not need to be too worried about being assigned as long as there is extrinsic value in there short option. Maybe sometime time you could do an article on that subject Tyler?
Good suggestion. I’ll add early assignment to my list of topics and see if I can get to it next month. Merry Christmas!
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