By Steve Papale
I love the seasons. To me there is something great about each one. And toward the end of one I am ready for the next. Around this time each year I start looking at another weather related item – increasing minutes of daylight. As I get older I have less tolerance for cold, dark days. So these days I start to anticipate spring by watching the increasing minutes of daylight each day. Right now in Chicago we are picking up over 2 minutes of daylight. Of course next week is the real indicator – groundhog day.
The last 2 weeks we have been going over the basics of options – an options boot camp if you will. Today we continue on as we delve into the price structure of options. Option prices are made up of 2 components – intrinsic and extrinsic value. Intrinsic value is how much the option is in the money. For example, with MCD trading at $120, the 115 calls have an intrinsic value of $5, that is they are $5 in the money. The intrinsic value moves up and down with the stock however can only be positive or 0. In this example the 125 calls have an intrinsic value of 0. By definition all out of the money options have an intrinsic value of 0. Puts work the same way. The 125 puts however are in the money (right to sell stock at $125, $5 over market price) and have an intrinsic value of $5. The 115 puts by contrast are out of the money and have an intrinsic value of 0. Finally all options go their intrinsic value (or parity) at expiration – either 0 for all out of the money options or the difference between in the money strike price and the stock price.
So intrinsic value is half of the price of an option. The other half is extrinsic value. Extrinsic value is risk premium or time value portion of the option price. Since options are essentially insurance products, people will pay a price above the intrinsic value of an option to account for the perceived risk in the market ahead. If risk perception is high, the extrinsic portion of option price goes up as more people bid for insurance. This increase in price is independent of what the stock price may be doing. For example, if IBM is announcing earning in 2 weeks, the uncertainty over what the earnings may be causes investors to bid more for options to protect against adverse price movements. The stock itself may go up or down ahead of earning affecting intrinsic value however extrinsic value increases for all options independent of the stock. When earnings are released, uncertainty is removed and extrinsic value likely will go down. By definition all extrinsic value must go to 0 at expiration. Since there is no more risk of price movement at expiration (prices are settled) there is no more risk or time premium in the options. The gradual erosion of extrinsic value over the life of an option is called theta. We will get into that later. Next week: implied volatility.