Getting a Handle on Intrinsic and Extrinsic Values
July 16, 2007
In order for an options trader to be successful, it is paramount that that he or she truly understands the concepts of intrinsic and extrinsic values. One of the most important concepts is time decay. Options are considered wasting assets in the sense that they expire after a certain period of time. As each day passes, the time to expiration decrease and the time value premium also decreases. To better understand this concept, you need to know what is meant by time value and intrinsic value as they pertain to option trading.
Time value, also referred to as extrinsic value, represents the amount the current market price of an option exceeds its intrinsic value. Intrinsic value is the amount by which an option is in-the-money. Out-of-the-money and at-the-money options have no intrinsic value, just time value. Four major components have an influence on time value, including time to maturity, interest rate, volatility of the underlying asset, and liquidity.
A very important point about the time value of an option is that as it approaches expiration, it decays at a very rapid level. In other words, at a certain point close to expiration, the near expiration options time value will move exponentially—meaning the closer an option gets to expiration, the more money it loses if the market doesn’t move in the direction that places the option in-the-money.
On the expiration day, all an option is worth is its intrinsic value; it’s either in-the-money or it isn’t. The further out from the expiration date the option is, the smaller is the impact of time decay, which is greatest in the last 30 days. These characteristics of time decay are extremely important to remember when trading options because they can be used to your advantage.
To illustrate this concept, consider a situation where the trader has purchased long options. Here, the trader is susceptible to time decay in the option’s value if the stock moves sideways. For each day the stock does not move, the option loses value. This loss in value is smaller the further out the trader goes out in time. The best way to reduce the impact of time value on the long option position is to use options with as much time to expiration as possible—based, of course, on the original risk/reward requirements.
When purchasing a long call or long put, for example, you want to have as much time as possible—not only for your option to move in-the-money, but also to reduce the impact of time decay in case the underlying stock moves sideways for a period of time.
Most traders do not understand this concept of time value or time decay because they think in the short term. When a stock is expected to move, many beginning option traders fall into the habit of buying options with less than 30 days to expiration because these are the cheapest. Using long-term options will reduce the effect of time decay greatly and therefore allow the trader to wait patiently for the expected move in the underlying stock without watching the position or money decay.
Just as option strategists can use time decay in their favor with the purchase of long-term options, they can also use time decay to their advantage by selling options. When selling options, the goal is for the option to expire worthless or buy it back at a lower price for a profit.
The option strategist should always sell shorter options with less than 45 days to expiration. Time decay works to the option strategist’s benefit on a short-term short option because it decreases the option’s value, thereby producing a profit for the short seller. Keep these impacts of time decay on both the long and short option positions firmly in mind before an actual option strategy is selected and implemented. By doing so, you will be a far better options trader.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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