By Josip Causic, Online Trading Academy Options Instructor
Every once in a while, I receive emails from our Online Trading Academy newsletter readers that very much communicate the same basic massage – "We did not understand your article on options." I always keep in mind my reading audience and attempt to go along with what the majority of the reading public requests according to their current need. A few months ago, in the article Back to the Basics, I made the following statement which still holds true today:
"The types of questions I have been receiving over the past month or so have been an indication that many of the members of the Online Trading Academy community are not at the level where advanced option strategies (such as Condor Spreads, Iron Condors, and multiple simultaneous option trades) can be easily comprehended."
Most recently, a newsletter reader's request led me to the venue where I had created a number of articles that dealt with option trading fundamentals. Since then, I have discussed various other issues, including 'strangle' and 'straddle.' However, the 'we just don't get it' sentiment mentioned above has made me pause and rethink what the underlying causes for this confusion could be. As it's in my nature to see multiple causes and possible solutions for most things, I decided to zoom out and look at this whole issue from a much broader perspective. I hope that some of my mindset and thinking philosophy came across clearly in the previous articles dealing with multiple exit strategies (and yes, here I am emphasizing the plural).
Hence, I asked myself the following two questions: Could it be that I did not explain straddles and strangles well? Or could it be that some of the members of the reading audience really have a lot of gaps in their knowledge of options? After several email exchanges, I was able to get an accurate answer to the specific questions that I had asked. Many students who contact me, honestly do not know the difference between the intrinsic and extrinsic time value of the option premium.
As such, I will spend this entire article making plain the difference between intrinsic versus extrinsic value. I fully intend to come back to the topics of 'strangles' and 'straddles' in the future and to revisit them separately rather than outlining them in a single shot as I did in the article, Strangles and Straddles.
At the same time, I am conscious of the other segment of our reading audience which has a more advanced understanding of options than the majority of our readers. To those of you, I would like to request your indulgence over the next several articles as I realize that some of the information presented below will seem somewhat rudimentary. Still, repeating is a good way of reinforcing what is already known. Hence, for those readers who are more advanced, just run with it. If you find that you did not learn anything … then that can be taken as good. After all, how do we, as individuals, know with certainty that we really have a good grasp of something? The answer is simple - when we can turn around and teach it successfully to others. I have learned over many years of teaching that the act of teaching material to an audience is quite a different experience than teaching it through published articles. One may be good at lecturing, but when it comes to presenting in writing, that is a different story … after all, there is no whiteboard to fall back upon as a complementary tool.
Anyhow, in order to explain the option premium in detail, one must go back and review a minimum of four primary terms: the option contract, the strike price, the expiry date, and the general concept of premium. After these terms have been addressed, the term option premium will still not have been completely defined. To do so will require the addition of at least four secondary terms. Figure 1 below lists all the different variances that are connected with this term.
# |
Primary Terms |
# |
Secondary Terms |
1a |
Option contract |
5b |
Assignment |
2a |
Strike Price |
6b |
Exercise |
3a |
Expiry |
7b |
Intrinsic Value |
4a |
Premium |
8b |
Extrinsic (Time) Value |
Figure 1
Four Primary Terms Explained
(1a) An option contact is a financial instrument with a certain defined, limited life. One option contract represents one hundred shares in the underlying stock. The contract gives to the option holder the right and/or obligation to obtain the underlying asset at the predetermined price and by the predetermined date. (2a) The predetermined price is called the strike price, and its selection is at the discretion of the option holder (buyer or seller). (3a) The predetermined date is also known as the expiry date. (4a) The price that we pay for the purchase of the option contract or the amount of money which we receive when we sell the option contract is called the premium. In simpler words, the premium is basically the total cost of an option.
Four Secondary Terms Explained
(1b) Assignment and (2b) Exercise are closely interrelated. One of the ways to explain them is to go through the exercise-assignment process. There are two sides to the assignment and exercise process depending on which side the option contract holder happens to be on: The buying side or the selling side. Basically the process involves the option (buyer) holder taking the non-passive action of actually notifying his or her broker of his or her intention to exercise the option contract. At that point, the seller is randomly selected and assigned from among all the sellers who are currently short that specific option contract. The seller, who got paid the premium up front, must then fulfill the obligation of the option contract's terms, which means that the seller must either buy to cover or sell the stock at the predetermined (strike) price.
Having explained these first six terms, I am finally at the point where the option premium can be clearly explained. There are basically two parts to any option premium: (3b) Intrinsic value and (4b) Extrinsic (Time) value. The premium is the sum of the option's intrinsic and extrinsic (Time) value. (3b) Intrinsic value is the amount of money, if any, that could be realized by exercising the option at its strike price and then instantly turning around and liquidating the acquired stock position at the current market price of the stock. (4b) Extrinsic (Time) value is the value of the option which declines as its expiration date draws closer. Figure 2 shows a visual presentation of the premium and what goes in it.
Figure 2 Intrinsic Value is that part of the option's value which is In the Money (ITM).
Time Value is the remainder of the option's value. Out of the Money (OTM) options will have no Intrinsic Value, and their price will solely be based on Time Value. Time Value is another way of say Hope Value. This hope is based on the amount of time left to Expiration and the price of the underlying asset.
A call is (ITM) in the money when the underlying asset price is
greater than the strike price.
A call is (OTM) out of the money when the underlying asset price is
less than the strike price.
A call is (ATM) at the money when the underlying asset price is the
same as the strike price.
With puts it works the opposite way:
A put is (ITM) in the money when the underlying asset price is less
than the strike price.
A put is (OTM) out of the money when the underlying asset price is
greater than the strike price.
A put is (ATM) at the money when the underlying asset price is the
same as the strike price.
In conclusion, I have reviewed eight important terms with the aim of explaining what an option premium is. The premium is the sum of the option's intrinsic and extrinsic (Time) value, and I attempted to explain each of these two pieces in detail. Knowledge of option premium, especially the size of the intrinsic value versus the extrinsic (time) value is absolutely essential when trading options. The goal of a net premium seller is to sell the premium that has no intrinsic value. Good Trading.
- Josip Causic
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