As you may have figured out, your option is not always profitable just because the current stock price is in favor of your contract. With buying stocks, it is simple– If the price goes up, you make money. Options are a bit more tricky. In this article, we are going to go over the two key components that determine an options price, referred to as intrinsic and extrinsic value.
Intrinsic Value
Beginning with the easier concept, intrinsic value is one you may already understand. I like to think of intrinsic value as the value of the option that you can logically see. You can see the value added or lost in your position when a stock price goes up or down.
When thinking about buying stocks, if the price increases from $50 to $55, the $5 difference would be known as the stocks intrinsic value.
Options can be looked at similarly. To find the intrinsic value just ask yourself “If my option were to expire with the stock price that it currently has, what would be the value?” It seems this would be the only thing to go into play, but the amount of time our option has until expiration also plays a role in determining the value.
Extrinsic Value
As explained in the beginning of this article, just because the stock prices are exactly where you want them to be, does not mean that your option will be profitable. Why is this? The answer can be found in extrinsic value, which factors in the time you have left in your contract. This time factor is either going for you, or against you depending on whether you are buying or selling an option contract, so we will look at both scenarios.
1. Buying an Option Contract
If you buy an option contract, time is not on your side. So if you buy a call, you need to pray that the stock price goes up soon after you buy it, and your goal should be to get out of that position as soon as possible. To be honest, it is fairly difficult for me to explain why this is the case.. but I am going to give it my best effort.
Imagine you buy a call with a strike price of $50, expiring in 25 days. Now, pretend that within the first 5 days the stock price moves up $5, which is very favorable to you. But, you now only have 20 days for the price to increase as opposed to 25. SO while buying options has a profit potential of infinity, every day that moves along you are decreasing your odds of making more money.
Main point: When buying an option, time is not on your side. The contract is most profitable in the beginning because there is a higher chance that the stock price will hit your strike price.
1. Selling an Option Contract
For another hard to explain reason, when you sell an option, time is on your side. With selling options, you may see a loss in the beginning due to extrinsic value, but as time passes you will start to see more and more value every day.
As the seller, the longer your option is OTM (or the stock price is in the range where you need it to be) the more likely you are going to be on the winning side of the contract. So while the buyer is decreasing the odds of making money every day, the seller is increasing those odds.
Main Ideas
If you are in an option contract which is not yet profitable, extrinsic value could be playing a key role if you are selling a contract. If the stock price is in the zone where you need it to be, just hold on to your position and you will start to see value being added to your position. Below are a few key points from this article:
- Intrinsic value– the value you can see. If your option expired today how much would it be worth?
- Extrinsic value– factor of time. What could potentially happen from now until your option expires?
- If you buy a contract time goes against you
- If you sell a contract time is on your side