Our last Options article was about the component of an option’s price called “time value,” also known as “extrinsic value”. This is the most interesting aspect of put and call options, and we’ll expand on it today.
The value of an option is made up of just two components. Extrinsic or time value is one of the two; the other being Intrinsic value. Let’s dispose of intrinsic value first.
Intrinsic value is the amount of positive cash flow that could be generated, if any, by exercising an option, and then immediately liquidating the resulting stock position at the current market price. Here are examples of intrinsic value for options on a hypothetical stock that is currently selling for $80:
A call option at the $75 strike. That $75 strike price is a $5 discount compared to today’s $80 market value. If I exercised the call, hypothetically, I could buy the stock for $75. Since I can sell it for $80, I could generate $5 in net positive cash flow. Notice that I said “cash flow,” not “profit”. Whether that $5 cash flow represents a profit depends on how much I originally paid for the option. But that $5 of hypothetical positive cash flow is today’s intrinsic value of that call option, regardless of my original cost. There is a term for an option that has intrinsic value. The option is said to be “in the money”. This option would be in the money by $5.
A call option at the $85 strike for that same $80 stock. Exercising that call would allow me to buy the stock for $85. Since I can only sell the stock for $80 today, exercising that option would generate negative cash flow (buy it for $85, sell it for $80), which makes no sense. Exercise of an option that you own is never required, and no one would exercise one like this today. This option has no positive cash flow at today’s $80 stock price, so it has no intrinsic value, and will have none unless the stock goes above $85. With no intrinsic value, this option is “out of the money”.
A put option at the $82 strike for our $80 stock. Exercising that put option would allow me to sell the stock for $82. I could buy the stock in the market for $80; then exercise the option and sell the stock for $82. Buy it for $80, sell it for $82, for a $2 net positive cash flow. That put has $2 of intrinsic value. Having intrinsic value, this option is in the money.
Finally, a put option at the $78 strike for our $80 stock. Exercising that option would allow me to sell the stock for $78. But without the put I could have sold it for more ($80), so I would never exercise that put at today’s prices. The put has no intrinsic value, and will not have any unless the stock drops below $78. Until then, this option is out of the money.
So, there is a simple formula for intrinsic value: for calls, it’s the current stock price minus the strike price, if that difference is a positive number. For puts, it’s the reverse – the strike price minus the current stock price (also if that difference is a positive number).
Since the strike price of any individual option is fixed, its intrinsic value changes as the stock price moves. The difference between the strike price (fixed) and the stock price (variable) changes when the stock price changes.
If intrinsic value was all there was to options, there would be no point to them. But it isn’t.
That’s because it is possible that the intrinsic value in any option could increase in the future. That will happen if the stock price changes in the right direction, and before the option expires.
For that reason people pay more for the option than just its present intrinsic value. They also pay for the possibility of an increase in that intrinsic value. The amount that they pay beyond the intrinsic value is the extrinsic value or time value.
The more change there could be in the stock price in the time before expiration, the more intrinsic value the option might acquire in the future; and therefore the higher its time value will be now.
The key to time value is “the more change there could be in the stock price in the time before expiration…”
How can anyone know how much change in the stock price there could be?
The answer, of course, is that no one can know that for sure. The best anyone could possibly do is to make an educated guess based on how fast that stock has moved in the past, and how long it now has to make its move.
There is an accepted formula for making that guess called the option pricing model. It takes into account a stock’s past rate of price change (called historical volatility); how long the option has until expiration; and how far away from the current stock price an option’s strike is. Given these, the amount of time value an option should theoretically have can be calculated.
That is the starting point for the option’s time value, but not necessarily the ending point. The rest is governed by the market’s expectations as to how fast the stock will move in the future. If they collectively think it will move faster than in the past, they will pay more for its time value and vice versa.
The key to successful option trading is understanding the three main forces that change time value – stock price, time passing, and market expectations – and positioning yourself to benefit from them. This is taught in Online Trading Academy’s Professional Option’s Trader course and Extended Learning Track. Contact your local center for more information.