Extrinsic value = option premium – intrinsic value
If implied volatility increases, extrinsic value increases.
A contract loses value as it approaches its expiration date.
Intrinsic value is the money you can make if the contract is exercised right now.
If a stock is trading at $55 and you buy the $50 strike price, you have $5 of intrinsic value.
A put option has intrinsic value when the underlying price is below the strike price.
A call option has intrinsic value when the underlying price is above the strike price.
Just like insurance, options have expiration and you have to buy every certain period of time.
More time equals more money. As time passes, an option’s value will decay.
Time decay isn’t linear, it’s exponential.
An option’s time value is always decaying 100% of the time.
Strike price: predetermined price at which the shares of stock will be exchanged if the option is exercised.
For calls any option that a strike price above the underlying price is out of the money If the strike price is below the underlying price is in the money.
For puts, if the strike price is above the underlying price, it’s in the money. If the strike price is below the underlying price, it’s out of the money.
Worthless at expiration means out of the money.
You do not have to hold the contract until expiration. If you buy a call option today with 30 days to expiration, and the stock goes up overnight and the call option is now worth $200 more now than when you bought it, you can sell it for a profit.
Expiring worthless means, the contract is worth nothing at expiration. Do I want it to expire worthless?
Time value equals extrinsic value.
Volatility is the magnitude of a stock’s price swings. Volatility equals more risk for stock holder. Options are worth more when there is more risk.
Different stocks have different volatility.
Volatility is predictable (mentioned in the book The Quants).
Option price equals intrinsic value plus extrinsic value.
Extrinsic value equals option price – (underlying price – strike price)
Why worry about extrinsic value?
As expiration approaches, extrinsic value diminishes.
When you sell a contract, you want to buy it back for less than what you paid for.
p.s. options are insurance for investors
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