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This chapter is from the book

This chapter is from the book

Extrinsic Value

Extrinsic value is based on a combination of the strike price, time, volatility, and demand. We like to think of extrinsic value as the "icing on the cake." Due to the nature of its components, it is impossible to estimate extrinsic value. Beginning traders often ask questions such as, "If I buy a call and the market goes up x number of points, what will it be worth?" Unfortunately, the answer depends on factors that can't necessarily be measured quantitatively.

Example

If a trader buys a September $6.00 soybean call option for 10 cents in June with the underlying futures price at $5.80 and the market rallies to $6.00 by the beginning of July, the option will likely be worth much more than the original premium paid. After all, there will still be a lot of time value left on the option and the option is now at-the-money.

Example II

If a trader buys the same option, in the same circumstances, but it takes the underlying futures until August to reach $6.00, the trade will likely be a loser. More time premium would have eroded from the option value than it would have benefitted from the market being closer to the strike price.

As you can see, it is possible to be right in the direction of the market and still lose money on a long option trade. This is exactly why it is so difficult to make money as an option buyer. It is hard enough to be right, but direction is only the first obstacle.

The extrinsic value of an option is based on a combination of the following factors:

  • Time
  • Volatility
  • Demand

Of these factors, time is the only predictable element. You know what they say, "Time waits for no man."

Throughout this book we will cover several hands-on examples to illustrate the risks and potential rewards involved with each strategy and scenario. It is important to realize that all calculations are based on the assumption that the trade is held until expiration. This is because at expiration the options will have no extrinsic value, which is nearly impossible to predict at any given point. At any time prior to expiration, the profit or loss experienced on the trade may be outside the original profit and loss parameters based on the price of the underlying contract at option expiration. This is especially true in the case of option spreads.

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