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Oct 23, 2020

"Applying the Pareto Principle to Options Trading Concepts" Takeaways

By:Mike Butler

The pareto principle can be applied to many things in life, including options trading! In this trade talk, Mike Butler explains why his main focus is on extrinsic value for most of his options trades, and why it’s such a powerful learning tool as well. Check out the segment and read this blog post for his main takeaways!

tradeTALK Key Takeaways
Episode Six
Applying the Pareto Principle to Options Trading Concepts w/ Mike Butler

The Pareto principle refers to the fact that a very concentrated input can (and often does) result in a huge chunk of the output you’re looking for. Otherwise known as the 80/20 rule or 95/5 rule, very specific things typically account for the majority of the result.

With exercise, maybe that’s consistency and nutrition. With options trading, extrinsic value is near the top of the list of things that apply to most aspects of things we look at, especially derivative metrics.

When you break down an option’s price, you can see that intrinsic value is easy to calculate - if an option is in-the-money (ITM), you can calculate exactly how much intrinsic value there is by measuring the distance between the ITM strike and the stock price. Any remaining value is extrinsic value, which is made up of time and implied volatility premium. As the stock price moves, IV changes, and time passes, extrinsic value changes and that has implications on the strategy you have.

In the example above, we’re looking at a short put contract at the 50 strike, with XYZ stock at $45. We know that the option has $5.00 of intrinsic value being $5 ITM, so if it’s trading for $6.00, we know $1.00 of that total value is extrinsic value premium. The big takeaway here is that option prices are very simple when broken down this way, and we can take out a lot of the noise by doing just that.

As you can see, extrinsic value plays a big role in the greek derivative metrics we look at every day. 

With delta, the more extrinsic value there is in an options chain, the more spread-out deltas will be from the stock price to 0 delta out-of-the-money. In other words, the more extrinsic value there is in an expiration, the wider the expected movement of the stock will be. The less extrinsic value there is, the more narrow the expected move will be.

The more time there is associated with a contract, the slower the extrinsic value will decay. With this simple fact, theta becomes a lot easier to understand without actually getting into the true calculation.

Through the lens of vega, we can see that the further out in time we go, the higher the vega number will be, which represents the change in extrinsic value of an option’s price given a 1% change in implied volatility. Everything comes back to extrinsic value at the end of the day!

The biggest takeaway from this deeper understanding of extrinsic values is that we can truly understand how gamma works as the stock price moves.

Consider this chart above while imaging the first bell-curve image of how the put value changes moving from OTM to ITM.

When an option moves ITM, it gains intrinsic value and loses extrinsic value. When an option moves OTM, it no longer has intrinsic value, so all of the remaining value is extrinsic value.

We tend to roll trades out in time around 21 DTE to avoid gamma risk, and this is exactly why - As an option approaches expiration, it will mostly be made up of intrinsic value and very little extrinsic value. That means a strike going from OTM to ITM can have massive implications on the net delta of the position. An option with more time until expiration, and therefore more extrinsic value, will have a much harder time realizing big changes in delta, simply because as that option moves ITM and gains intrinsic value, it also has a lot more extrinsic value to lose, so the change in delta and change in the option price ,in general, will be much more muted.

This was one of my favorite a-ha moments, and one of the big reasons why I started focusing on extrinsic value much more, and that led me to a much more simplified approach to options trading - if you can understand extrinsic value, you can understand any greek derivative that incorporates extrinsic value in some way shape or form!

Watch Episode 6 and tune in next Thursday, October 29 at 3pm CT for Episode 7, Reducing Trading Costs in Expensive Markets with Frank Kaberna.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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