This chapter is from the book
This chapter is from the book
This chapter is from the book
Valuation of Options
Every option has an overall value, known as its premium. But the total premium consists of three specific parts: intrinsic value, time value, and extrinsic value. The first two are quite easy to understand, but extrinsic value is where all the variations are going to be found. For example, if you look at two stocks with the same market value and with options for the same strike and expiration, you are still going to find differences in those option premiums. The reasons are explained by extrinsic value.
Intrinsic Value
The option’s intrinsic value is easy to understand. It is the point value equal to the option’s in-the-money level. For example, a 30 put has three points of intrinsic value when the underlying stock is at $27 per share ($30 − $27 = $3). If the stock’s value is higher than the put’s strike, there is no intrinsic value.
A call has intrinsic value whenever the underlying stock is higher than the call’s strike. For example, if the strike is 45 and the current value of the underlying is $51 per share, the call has six points of intrinsic value ($51 − $45 = $6).
Intrinsic value will always track with the underlying stock’s price movement. For a put, the intrinsic value increases point-for-point as the stock value falls; and for a call, intrinsic value increases point-for-point as the stock’s value rises.
Although intrinsic value is easily defined and understood in the sense that it moves point-for-point with the underlying, the total premium does not always change exactly with price changes. The variation occurs because of the nature of extrinsic value (explained later). When you see a stock’s price move by three points and the option change by only two or perhaps by four points, the explanation involves an offset between intrinsic and extrinsic value. So although intrinsic value does change predictably, total premium may offset that movement because of price adjustments made in extrinsic value. The risk and volatility of the stock, time to expiration, and changing technical information about the company all have an effect in extrinsic value.
Time Value
Time value is just as easy to track as intrinsic value. The longer the time to expiration, the higher the time value. As expiration approaches, time value declines and the rate of decline accelerates as expiration nears. So there is going to be very little change in time value for a LEAPS option with two years to expiration, and a very rapid deterioration of time value during an option’s last two months of life.
Option buyers struggle with time value, because declining premium levels make it difficult if not impossible to build profits in long option positions. For example, if you buy an out-of-the-money put for 3 ($300) and with six months until expiration, you need the underlying to move down by three points in-the-money (below strike) just to break even by expiration; and it has to move even further to make any profit.
Option sellers benefit from declining time value for the same reasons. For example, if you sell an out-of-the-money put for 3 ($300) and with six months until expiration, you need the underlying to move only by less than three points in the money to make a profit. Because none of the premium is intrinsic, as long as the stock remains at or above the put’s strike, it is easy to profit from declining time value at any time before expiration.
Extrinsic Value
Of the three types of premium in an option, extrinsic value is the most interesting and the most complex. It is a reflection of the price volatility (market risk) of the underlying stock. The more volatility, the higher the extrinsic value as a rule. But the longer the time to expiration, the more variation you will find in intrinsic value. It is even possible that increases in intrinsic value will be offset by declines in extrinsic value—due simply to the fact that a lot can happen in an extended period of time.
For example, you buy a put LEAPS with 24 months until expiration. Strike is 25 and the stock currently is at $25 per share (at the money). Total premium is 7 ($700). You believe the stock’s market value will decline and create a profit in coming months; you are also aware that the entire premium consists of nonintrinsic value. Over the following month, the underlying declines to $21, a drop of four points in the money. However, the option premium grows only to 9, a change of two points.
In this case, two things have occurred. There is little or no change in time value because the time to expiration is so far off. Intrinsic value increased by four points ($25 − $21 = $4); but extrinsic value fell by two points (4 − 2 = 2). This offset is an odd combination of factors. It contains the influence of time and volatility. With 24 months remaining until expiration, the offset between intrinsic and extrinsic value is a way that the market questions whether that particular option should be priced for the entire amount of intrinsic change. While the adjustment is made to intrinsic value, time has a lot to do with this offset; if there was less time remaining in the life of the put, the offset would not be as severe and, in fact, it might not occur at all.
Extrinsic value plays a role in option premium that modifies the effects of both intrinsic and time value. Neither of those portions of the option premium change as part of this price adjustment. Because intrinsic and time value are specific and exact, the change is extrinsic only. Remember, both intrinsic and time value are predictable. Intrinsic value reflects the number of points in the money (so when the option is at the money or out of the money, there is zero intrinsic value). And time value changes on a time-based curve and does not change over time. Time value is affected solely by the proximity of expiration.
Even though these rules are specific, extrinsic value is affected by both the degree of intrinsic change and the time until expiration. This complexity explains why a longer-term in-the-money option premium does not exactly track changes in the underlying; it also explains why even out-of-the-money options are often quite unresponsive to changes in the underlying. For example, a long-term put that is out-of-the-money might have little or no change in the premium even when the underlying moves closer to the strike price level. The unresponsiveness of the option premium in long-term out-of-the-money status makes sense because you cannot expect more point-for-point changes until (a) expiration is much closer and (b) the option is in the money.
The variation between degrees of stock price change and option premium change is called implied volatility and defines option values when they do occur. An option’s premium is almost always worth at least its intrinsic value, and in cases in which it falls below that benchmark, it is going to be very temporary. Because both intrinsic and time value are specific, any bargains in option pricing are going to be found in adjustments to extrinsic value, known as an evolving trend in the option’s implied volatility.