Papale on Extrinsic Value

By Steve Papale

It seems with less than 500 days until the Summer Olympics kick off in Rio de Janeiro that the events that occur on the bay, like rowing, will have a different twist.  The promise to clean up the massively dirty Guanabara Bay won’t be done in time.  Organizers however promise that events will take place in the cleanest part of the bay.  I wonder if officials are coming up with a handicap system for rowers hitting floating tires and dead fish.

Extrinsic value is what separates options traders from futures or stock traders.  The option price is made up of intrinsic and extrinsic value.  Intrinsic value represents the share exposure to the underlying.  The extrinsic is the risk premium above and beyond what the option is worth intrinsically.  It is where most option selling strategies earn their return.  For covered call and put sellers the extrinsic value is what generates yield.  So here are a few practical things an option trader can use when managing his trades.

First, if the option you are short is in the money, a quick way to determine the extrinsic value is to look at the corresponding strike of the other option.  For example, if I am short a 100 call that is in the money, I can look at the 100 put and its price is the extrinsic value.  Remember, both the call and put at the same strike are trading theoretically at the same IV so will have the same extrinsic value.  Out of the money options have no intrinsic value so their price is all extrinsic value.

Second, maximum yield is generated by selling an at the money option.  Highest extrinsic value is at the money so that will generate the highest yield.  It does not mean it will generate the highest return.  If the stock runs up hard our participation is capped.  In a case like this, an out of the money call would generate a lower yield but higher overall return as the stock can participate in rally more.

Finally, we have talked about the fact calls are only exercised early on the day before a stock goes ex-dividend.  Of course in reality an American option call holder can exercise anytime he wants but economically he will only do so ahead of ex-dividend day.  A rule of the thumb is if the dividend is more than the extrinsic value, the call will be exercised.  This is because when the call holder exercises he will lose any remaining extrinsic value left in the call.  So the dividend collected must be more than the extrinsic value lost.

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