Option Pricing

There are two primary components related to the price of an option: extrinsic value and intrinsic value.

Underlying Stock Value + Time Value = Option Value

Intrinsic Value

Intrinsic value is the true value of the option if it were to expire immediately. Intrinsic value is the difference between the market value of the underlying stock and the strike value of the option.  As the stock value changes from day to day, the intrinsic value is affected as well.

As an example, let’s say $AAPL is trading $320 and earnings are coming out the next day.  You choose to buy a call option with a $325 strike price, making the option worth $500 ($5 x 100 shares).  If the earnings report causes the stock to go up to $335 the next day, the intrinsic value of the option will increase to $1500.

However, the price of the option is also affected by extrinsic value, and this can have an affect on the outcome of the trade.

Extrinsic Value

The extrinsic value is a bit more complicated.  The extrinsic value is the component of the option value that eventually becomes zero on expiration day.  Prior to expiration, the extrinsic value represents the is the amount you are prepared to pay for the possibility that the market will move in your favour during the life of an option so that you will profit on your purchase.

Extrinsic value is affected by the following factors:

  • time to expiry
  • volatility
  • dividend payments
  • market expectations

Out of the Money (OTM) options have no intrinsic value, and are only valued based on the implied risk or opportunity that the underlying stock will move to a particular strike in the given amount of time.

Using Theta

One of the “Greeks” in option trading that is monitored by traders who focus on selling out of the money calls and puts is Theta. Theta is an estimated measurement of how much money you will collect on time decay per day until the day the option expires when you write, or become a seller of options.  The higher the theta, the better for the option seller, (also known as a writer). Most brokerage platforms will state for you the theta of an option position, along with delta and other “Greeks”.

Selling Extrinsic Value

Selling extrinsic value to option buyers is a way to make high probability trades, while limiting risk.  Focus on underlying stocks with high implied volatility, and sell far enough out of the money that your probability of success is at least 65%.  Its a good method to close these types of trades when you can buy it back for half of what you sold it for, or 50% of the profit.

Even more important than implied volatility is implied volatility rank (IVR).  Because implied volatility ranges for each underlying stock or ETF are unique, the IVR will tell you how the IV for that particular stock is trending.

How can you learn a stock’s implied volatility rank (IVR) on any given day?  If you open an account with Tastyworks and use their web or standalone platform, both will give you the IVR of any underlying stock.  Or you can calculate it yourself.  For more information about how implied volatility works, visit this lesson on Tastytrade.

Implied Volatility on Tastyworks
IV rank on Tastyworks for each stock tile is circled in yellow.

An Example of a Trade Selling Extrinsic Value

For example, let’s say $BA (Boeing) is trading at $338 per share, and you wanted to sell the $325/$320 vertical put spread with 30 days to expiration.  In this hypothetical scenario, $BA has implied volatility of 27, and you can collect around $1.23 per vertical spread you sell.   This is worth $123 per spread if you bought it back for $0.  Or, you could buy it back when its worth $60, or around 50% of the profit.  A trader can profit from this type of trade if $BA goes up, stays at the same price, or even drops, as long as it doesn’t drop below $323.77 before expiration.