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Extrinsic Value

Best Practices

We are generally option premium sellers and almost always that is in out-of-the-money (OTM) options. That means we are selling extrinsic value. The intrinsic value of an option is the difference between the price of the stock and the strike price. Extrinsic value is the remainder. It is the risk premium. Since an OTM option has no intrinsic value it is all extrinsic. How is the extrinsic value determined and what can we learn from that?

A table of the inputs used in the Black-Scholes model to calculate the value of an option was displayed. The table included the stock price, strike price, Days To Expiration (DTE), Implied Volatility (IV) and interest rate. The only unknown variable is IV. A table comparing at-the-money (ATM) Straddle AAPL options with 45 DTE was displayed. The table compared the same option in a time of distress on January 12, 2016 (IV at 37.5) versus the present time of relative tranquility (IV at 21.5). The table demonstrated how the extrinsic value rises in times of distress (35%).

Tom stated, "Our whole argument is let's wait for overpriced or inflated fear and try to take advantage of 2 things working for us. One is being right directionally, and two a contraction in Volatility. It's easy to figure out. Implied Volatility measured against itself is IV Rank, that's why we have so much focus on IVR and this is a great example in AAPL."

A table comparing the extrinsic value of the ATM Straddle with 45 DTE in various stocks was displayed. The table showed that traders pay more for protection on high-flying stocks whose future they are less sure of, such as Tesla (TSLA) as compared to more stable stocks like GE and KO. Because of uncertainty in the future, the extrinsic value on options that expire further out in time will be greater. A final table of SPY (S&P 500 ETF) options compared the ATM Straddle with different DTEs. Because traders are willing to pay more for longer-term protection, the extrinsic value of options further out in time is greater.

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of extrinsic value, its relationship to Implied Volatility and what that means for us.

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