Option premium value contains three different classifications, each with its own unique attributes. Most descriptions of value are limited to intrinsic and time value; but in fact, time value premium has two parts, true “time” value and a second type, extrinsic value. This last category is where all of the unpredictability resides, where volatility is going to be found, and where the mysteries of option value are in play.
Once you understand how extrinsic value interacts with intrinsic and time value of an option, you are better suited to select underlying stocks most suitable for your strategy, and to manage stock and option risks more effectively.
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The intrinsic value of an option is restricted to the number of points it is in the money. This is the point range when the current value of stock is higher than a call’s strike, or lower than a put’s strike. The time value is the portion of the premium associated with time remaining to expiration. Time value declines as expiration approaches, with little or no time value remaining at the time of expiration. Extrinsic value is the portion of option premium that increases or decreases due to volatility and market risk, and which may offset changes in intrinsic value caused by movement of the underlying stock.
When an option is out of the money — meaning current market value is lower than a call’s strike or higher than a put’s strike; all premium is time and extrinsic value. When the current value of a stock and an option’s strike are identical, the option is at the money. The proximity of current price to the strike is essential in judging the relative value and volatility of an option.
The time value of an option is entirely predictable. Time value premium declines at an accelerating rate, with most time decay occurring in the last one to two months before expiration. This occurs on a predictable curve.
Intrinsic value is also predictable and easily followed. It is worth one point for every point the option is in the money. For example, a call with a strike of 30 has three points of intrinsic value when the current value of the underlying stock is $33 per share; and a 40 put has two points of intrinsic value when the underlying stock is worth $38.
The third type of premium, extrinsic value, increases or decreases when the underlying stock changes and when the distance between current value of stock and strike of the option get closer together. As a symptom of volatility, extrinsic value may be greater for highly volatile underlying stock, and lower for less volatile stocks. Extrinsic value is the only classification of option premium that is unpredictable.
Historic versus implied volatility
The term “volatility” refers to level of predictability or risk. There are two types, historic and implied. Historic volatility refers to stocks, mutual fund shares, and other equity accounts and the degree and rate of price changes. A stock with a broad trading range and a tendency for price to move rapidly up and down is highly volatile; making is less predictable than a more stable, low-volatility stock. As a rule, stocks with higher than average historic volatility also tend to have associated options with higher premium levels. As the price varies based on volatility, it is also a symptom of changing risk levels.
This brings up the second type, known as the implied volatility of options. It is called “implied” in recognition of an option’s tendency to change based on price changes in the underlying stock, especially when current market value is close to the option’s strike price. In studying the cause and effect of option premium levels, it often occurs that expected movement in the underlying stock may be factored into option premium values before the move occurs. As a consequence, option premium value (and specifically, extrinsic value) at times is unresponsive to movement in the underlying stock, even when the option is in the money. The premium value may even move in a direction opposite that of the underlying.
Equally important, options with a long time to expiration, notably out-of-the-money contracts, tend to be very unresponsive to underlying price movement. Even when the strike is passed and the contract goes in the money, long-term option implied volatility is likely to change very little, because time value dominates the overall premium level. Given the time-only element, it is quite difficult to estimate the appropriate level of extrinsic value, meaning that implied volatility is the “great unknown” of long-term option value. As expiration nears (and especially when strike and current value are close), the option premium becomes more responsible and intrinsic value is increasingly likely to track stock price movement.
To appreciate the meaning of an option’s implied volatility, remember the definition of implied volatility: It is a quantification of the rate and degree of price changes in extrinsic value, based on changes in the underlying stock. At times, options are going to be either under- or over-valued. The formula for strategically playing these conditions is to sell over-valued options and to buy under-valued options. However, such trades have to be entered quickly because the variances in implied volatility value tend to change rapidly. The more traders realizing these disparities, the more rapidly the disparity becomes absorbed in the option pricing level. Fortunately, you do not need a degree in statistics to calculate implied volatility levels. Many different brands of options analytical software or online options tracking sites provide this type of information at a moment’s notice. Many commercial brands can be purchased or are provided as part of subscription services. A free version of calculator for implied volatility is provided by the Chicago Board Options Exchange (www.cboe.com). Go to the link for “Trading tools” and then to “Volatility Optimizer” and check the “IV Index” and “Options Calculator.”
Using extrinsic value as a test of stock risk
While most analysis of implied volatility is applied as a test of immediate value of contracts, the opposite use also provides value. You can use implied volatility as a defined level of extrinsic value to test volatility of a particular stock. Just as you want to be certain to avoid buying or selling calls when the pricing is wrong, you may also want to avoid buying stock in exceptionally high-volatility companies. The market risk seen with historic volatility may make option premiums attractive at the moment; but if a particular options strategy includes the need to buy shares (in the covered call strategy, for example) you also need to ensure that the stock’s volatility level is a suitable match for your personal risk profile. By testing implied volatility, you will be able to identify whether extrinsic value is high or low at the moment.
Remember, both time value and intrinsic value are predictable and known in advance. The volatility or extrinsic value of options is where all of the variation occurs. Knowing when extrinsic value is too high or too low is a smart way to buy and sell options. It also helps you to pick the most suitable stocks, both for long-term investing and for options strategies.
Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes fulltime.
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