An option’s price is the product of two fundamental elements, extrinsic and intrinsic value. What is the relationship between these two price making values and how should we use this connection to trade?
Extrinsic value encompasses the risk premium in an option whereas the intrinsic value embodies the current exercise value of the option. These two values although paired are inversely related. As intrinsic value increases, the extrinsic value decreases and vice versa.In terms of pricing, at-the-money options(ATM) and out-of-the-money(OTM) options have an extrinsic value of 100% and an intrinsic value of 0%.In-the-money(ITM) options gain intrinsic and lose extrinsic the further ITM the strikes.
Tasty Trade supports buying ITM options and selling OTM options for debit spreads and diagonals to increase the probability of profit and minimize negative decay. For short premium trades, we sell OTM options due to their extrinsic value being 100%.