The Importance of Extrinsic Value in Options | Options Crash Course

[Music] i'm jim schultz and welcome back to the options crash course man moving right along we are now two episodes in in our 17 episode crash course so we gotta get right into it man cause we have a lot to cover here in episode number three so without further ado let's pop right in so what we're going to do today is we are going to cover some extrinsic value extras now let me say this on the front end i will probably say this as a disclaimer to every single episode inside of this crash course but extrinsic value guys this might be the thing that we focus on more than anything else at tastytrade this might be the most important concept in all things tasty treat you're probably going to hear me say that no less than a dozen times over the course of the next 14 days but this actually might be it so naturally there is no way i could possibly do this justice in you know 19 or 22 minutes but i'm gonna give it a try so this is episode three we're going to talk about some extrinsic value extras so just to kind of recap where we've been so far and to kind of look forward and forecast where we are going next so we've already covered day number one the source of all strategies that was just a couple of days ago we then just yesterday deconstructed some option prices between the black shells option pricing model intrinsic value extrinsic value and of course today we're going to dive even deeper into extrinsic value and learn some of those extras that do indeed exist inside of this one concept and then tomorrow for episode number four we are going to talk about profit direction and probability which believe it or not are all pointing back to the same variable so that might tickle your fancy a little bit but we'll have to save that for tomorrow okay so here's what we're going to do to best learn about extrinsic value you actually have to back up a step and you need to make sure that you understand intrinsic value and to understand intrinsic value i kind of alluded to this at the end of yesterday's episode we first need to familiarize ourselves with the idea of moness so moneyness comes in one of three forms there is atm at the money itm in the money and otm out of the money these are very very important terms that you are going to hear me slash us at tastytrade use all the time in our trading all the time in you know the construction of our portfolios in the selection of our strategies like you're going to hear these terms just used all over the place so it is very very important to understand what they mean and what they represent and you know everything that we do is cumulative right everything that i'm doing inside of this crash course specifically it builds on itself right episode one and then episode two builds on episode one and then episode three builds on episode two i've created this crash course in such a way that it has a a a consistent theme from one episode to the next so that for those of you that do find this you know after the fact you know in the archives on tastytrade maybe on a youtube playlist or something of that nature if you watch this thing from one episode to the next then you're going to see and grab onto that consistent theme all the way through that building nature of the content we saw moneyness a little bit yesterday we're going to talk about it in more detail here today this is the only thing the only thing that is controlling the intrinsic value of an option and when i say only i mean only i don't mean only with the berry bonds asterisk i mean only i don't mean like some of the time this isn't gonna work or you know in these really random situations it's going to fall apart like no i mean that moneyness is the one and only thing that is controlling intrinsic value and we're going to understand why here in just a couple of minutes but that's what we're going to look at first then secondly we are going to dive into extrinsic value we are going to take the leap into extrinsic value and try to learn and understand some of those extras and the two most important ones that we're going to focus on here today are time and volatility and what we are going to see hopefully somewhat clearly is that time and volatility have the biggest impacts on extrinsic value and the reason why they have the biggest impacts on extrinsic value again it traces back to the source right it traces back to one of the things that we learned on day number one with the source of all strategies compensation if you remember payment and compensation if you remember that relationship between the long side of the option contract and the short side of the option contract and the nature of it being a zero sum game and the nature of the long paying the shorts if you guys can just remember that one aspect a lot of what we talk about just in a general sense is going to make a lot of sense but what we do what we're going to talk about here today specifically with time and volatility it's going to make a whole lot of sense so that's what we're going to talk about here today so all right so the first slide moneyness is life now i have a couple of cards here on the slide this is very similar to what we talked about yesterday but i wanted to revisit this idea to not only you know go around the merry-go-round one more time because repetition is absolutely the key to mastering you know any new domain but we know more now we've learned some new terms right we now understand more of the space so we need to revisit this idea and be a little bit more precise and accurate with our terminology so using the idea of moneyness and applying it to both call options and put options let's work through a few examples a few scenarios to make sure that we all understand moneyness perfectly well if i'm talking about call options so now i'm on the left hand side of this slide i'm working with those gray cards that you see if i'm talking about call options a call option would be in the money if it has value to the long side of the contract remember right i suggested that we always look at things at least first and foremost from the vantage point of the long side of the contract that is very advantageous to our understanding and learning this space from the viewpoint of the long side of the contract the value of the contract is in the money of a call contract if the price exceeds the strike so in this example the price might be 75 and the strike price that's of course the stock price is 75 the strike price is 60. so again this call contract has an inherent value it has an inherent worth of in this example 15 because the long call holder can buy stock for 60 when it's actually selling for 75 so there's some value there if on the other hand moving down to the the gray card beneath the card we were just looking at if the strike price is still 60 but now the stock price is 50 this would be an out of the money situation this call option would be out of the money and why is that the case because it basically has no inherent value to the long side so we would call this an out of the money contract why doesn't it have any value to the long side because why would i buy something for 60 when i can go into the open marketplace and buy it for 50. well we've talked about this a couple of times you might be rock solid on this concept but just to make sure that we have you know these foundational elements you know in place it definitely pays dividends pun intended to go over it a time or two here today so that's the call option those are in the money and out of the money call options let's move all the way to the right hand side of the screen with the yellow cards these are going to be the put option examples that i want to work through with you guys so the top yellow card let's suppose that the stock price is 75 and the strike price is 60. in this case this put option would be out of the money so again remember a put contract gives the long side the right or opportunity to sell at the strike price why would i sell something for 60 the strike price that we have in this example when i can just go into the open marketplace and sell it for 75 right that situation would be an out of the money put you can kind of see it's the reflection right it's the mirror image of the call scenario because again the call gives the long side the right to buy the put gives the long side the right to sell so of course they're going to kind of be you know an oil and water scenario right a yang and yang scenario if we then move to the bottom yellow card so the last card on the screen we see the other scenario with the put option if the stock price is 50 and the strike price is 60 now all of a sudden i've got something right now all of a sudden i'm cooking with coconut oil because i can sell this thing for 60 when it's only selling for 50 in the open marketplace so it's like wow all of a sudden this contract has some value so in this scenario it is going to be in the money so those are in the money and out of the money calls and puts at the money scenarios it doesn't matter whether you're talking about a call or a put it makes no difference an at the money situation is where the stock price is equal to the strike price so in this case the stock price is 60 and the strike price is 60. it could be stock price of 100 and strike price of a hundred stock price of 300 in strike price of 300 right it doesn't matter those two values are equal so hopefully having gone through this a little bit you know in the money out of the money and at the money all kind of make a little bit of sense so let's turn our attention now to the faq that i have on the screen this is probably the most common question that i received as i was a professor before i joined tastytrade and still get this question asked on a fairly regular basis you know from the old uh questions that come in from all of our viewers so if i'm understanding this situation correctly jim in the money must be a good thing in the money must be a positive thing because i mean just think about the term right i mean the term would you rather be in the money or out of the money it's effectively saying would i rather have money or not have money like i don't know about you all but i think i would prefer to have money right so the the very labeling of the these money-ness options if you will in the money appears to be far more attractive than out of the money the answer to this question is yes it is a good thing if you are the long side of the contract now let's step aside for a second and let's remember you don't have to be the long side of the contract you can be the short side of the contract right remember when this game begins when the option contract you know is established if you will you can freely choose which side of the game you want to play this from you can play it from the long side you can play it from the short side now i know what some of you are probably thinking i'm even going to hop on the soapbox for this some of you guys are out there thinking all right jim bro like come on man like i've been tracking with you so far but i got to stop you right here because this sounds like a trick question right you're trying to tell me that i should consider the short side you're trying to tell me that i shouldn't just automatically go for the long side because if everything you've told me so far is true which let's be honest i found you on the internet so i'm not quite sure that it is but let's assume that it is if everything that you've told me so far is true i remember from episode one that the long side of the option contract has effectively the potential for unlimited gains that's a plus and limited losses that's a double plus whereas the short side of the option contract effectively is set up for limited gains that's a minus and the potential for unlimited losses that's not even a double minus that's a triple minus so why would i ever consider the short side of the option contract well if you have that question right now and you're starting from scratch which again is my assumption working through this crash course that's a great question that's a very sophisticated question to have and you should be asking that question right now and all i'm gonna say is this fair enough you're on to something but let's press on anyway and i have a sneaking suspicion that you might change your mind at least a little bit in about eight and a half minutes so let's pop in let's pop back into the deck here and kind of see where the wind blows us okay so moneyness is life so we've now established that point even belabored that point a little bit now let's turn our attention to extrinsic value so if you guys remember right the black shoals option pricing model that we've already talked about at least briefly and at least loosely has six different inputs right those six inputs you see on the screen here the stock price the strike price the dividends time volatility and interest rates you see all six of them on the screen here in different ways and they're presented in their own unique formats but all six of them are on this slide what i want to draw our attention to are the two that are in blue in the center time and volatility so we'll come back to those here in just a second but that is where i'm heading on this slide the stock price and the strike price are not as relevant for determining extrinsic value as they are for determining intrinsic value now that's not to say that they don't play a role because they do and that's not to say that their impact on extrinsic value is totally insignificant because it's not but just to narrow our focus a little bit right i've got to make some concessions along the way inside of this crash course let's put stock price and let's put strike price on the shelf when it comes to understanding extrinsic value let's not worry about those so much right now let's just let's all agree that stock price and strike price are going to impact the intrinsic value more than the extrinsic value and let's just hone in on the remaining four inputs so dividends rates time volatility okay working through the process of elimination some deductive reasoning here on episode number three of the options crash course what i want to do now is let's also get rid of dividends and interest rates in terms of the impact that they're going to play on extrinsic value and i'm going to do this for two reasons the first reason is this let's go interest rates first the impact of interest rates on option prices it's there it's meaningful it's in the equation but it's just not that relevant it's just not that impactful and the main reason why is simply because interest rate changes when they change globally when they change in the united states they don't change you know in these wide sweeping motions right like you don't see the federal reserve come out and change interest rates by 300 basis points or 200 basis points right a massive change to interest rates would be 50 basis points sometimes even 25 basis points depending on the market expectations and so the changes in the actual model in the equation number one they're very infrequent and number two they're very very small in their absolute value so for those reasons alone interest rates are not going to play a big role in extrinsic value what about dividends dividends do play a role in extrinsic value but we need to remember that first of all not all stocks pay dividends so if i'm dealing with a stock that doesn't pay dividends like amazon for example like chipotle for example right like tesla for example these stocks don't pay dividends so the dividend variable is literally non-existent when it comes to the black shells model and the pricing of these options and so a lot of stocks don't even pay dividends now for the ones that do pay dividends there is a time in a place where something called dividend risk is going to be a factor that you need to consider but we're going to put that on the shelf right next to the stock price right next to the strike price you know right in between the oregano and the deal weed and we'll pull it back down at some point in the future let's turn our attention to time and volatility so what you see next to both time and volatility is a pair of yellow arrows so i wanted to make this as simple as i possibly could because these both time and volatility each in their own right very very involved very very complex metrics that are impacting the extrinsic value of an option so let's simplify this for our first crack at understanding this concept and what i want you guys to do is i want you to remember think about the compensation between the long side of the contract and the short side of the contract think about who's paying who and think about who is bearing all the risk so if we take a look at time first let's start with the time variable if there is more time in an option ceteris paribus which means all other things equal which all of my economist friends out there know that we use that term when we don't feel like explaining all the other things that are occurring that actually happen in the real world we just want to focus on this one element right so ceteris paribus if there's more time in an option and everything else is the same the stock the strike everything else is exactly the same and you're comparing you know an option that has 10 days to go to expiration versus an option that has 90 days to go to expiration every single time and again every single time no questions asked the longer dated option is going to sell for a higher price it's going to sell for a higher price because it's going to have more extrinsic value so the two yellow arrows that are next to the time variable what they mean is more time means more extrinsic value now you might be wondering jim why is that the case right that was going to be my faq for this slide but you can see this slide it's already jamming to the max so we didn't have any room for any faqs but naturally you would be asking how can you be so sure that that has to be the case well again if we go back to the compensation between the long side and the short side it all makes sense remember the long side pays the short side of the contract doesn't matter if it's a call option doesn't matter if it's a put option put another way the short side charges the long side because remember the long side has the opportunity for unlimited gains on the call side and effectively on the put side too although of course stocks can only go down to zero because of that relationship because of that kind of cause and effect and that payment that occurs from the long to the short the short side is bearing all the risk right remember again we've seen it now we saw it today we saw the first episode we saw yesterday right if you are short an option contract you effectively have unlimited risk if you're going to want me to carry that unlimited risk for a longer period of time 90 days as opposed to 10 days in our little example here what am i going to do i of course am the short side of the contract i'm going to charge you more right i'm going to jack up my rates i'm going to increase my prices because you're asking me to bear unlimited risk for a longer a larger window of time a longer duration naturally i'm just going to charge you more for that right so that just makes perfect sense intuitively based on everything that we've learned so far so that's why when the time variable goes up you will always see the extrinsic value go up okay moving on to volatility the final piece that's on this slide you see the same relationship that we just saw with time you see two yellow arrows both pointing higher and you're naturally able to conclude okay if there was more volatility that means there's going to be a higher extrinsic value which of course is going to lead to a higher options price but you might be wondering well why is that the case well again think back to the risk relationship between the long side of the contract and the short side of the contract think back to who has the potential for unlimited gains and who has the potential for unlimited losses and who is paying who you what you're going to end up with is a very similar story line a very similar conclusion to what we just saw with the time variable and here is kind of how it works again ceteris paribus everything else being the same the strike the stock the time dimension are all equal if we're comparing two different options two different stocks one has a higher volatility and one has a lower volatility again if i am the short side and you're the long side right what am i going to do if you want to engage in an options contract with me in a higher volatility stock higher volatility of course simply just meaning the stock is going to bounce around a lot more what am i going to do i'm going to charge you more for that why am i going to charge you more for that well it's very simple i'm on the hook for unlimited losses and if this stock bounces around a lot there's a greater likelihood that it might shoot through the moon right or of course go down into the toilet if it's a put option either way the likelihood that it does something crazy and wild and i'm on the hook for all those losses is higher if the volatility metric is higher and remember the long side has limited losses the long side can simply walk away right if the option ends up out of the money right using some of the terminology we just learned and i'm long you're long you just walk away you don't have to use it but the short side of the contract must fulfill his or her obligation if the long side wants to exercise that option because it's in the money i can't just walk away i can't just say yeah just kidding right i've got to fulfill that side of the option contract so if the volatility is higher the stock's going to move around a lot more there's a greater likelihood it could end up deep in the money so what i'm going to do as the short side i'm going to charge you more so the most important thing that i want you guys to see at this point is more time means more extrinsic value which of course means higher option prices more volatility means more extrinsic value which again means higher option prices so all right so now we have about five or six minutes left what i want to do is i want to round this thing out with a nice little three-step process for how you can begin to put all of this together so follow me through this little three-step column that i've built for you guys so the first step is this we learned about the black shells option pricing model right and naturally you would use that equation or set of equations to calculate an option's price that is the general spirit of the model that was the original intent of the model but as traders what we learned right many many years ago i mean my my forefathers the pioneers in this space tom tony what they started to do is they started to realize like hey wait a second what we need to do here let's not calculate the options price why would we do that right we know the options price it's staring right back at me on the board right why don't i use this model instead to calculate the only variable that i can't see the only variable that i don't know with certainty implied volatility the only variable that i don't know with certainty is implied volatility the forecasted volatility for the next period of time whatever period of time that might be might be 20 days might be 45 days might be a year it doesn't matter for some forecasted period of time what is the implied volatility for that window of time let me calculate that well we can certainly use the black souls model to do that so rather than calculate an options price we simply calculate the implied volatility instead okay so now that we have that in our back pocket here's the next thing that we need to understand this is critically important if you are multitasking right now come back to me if you have 49 tabs open on your google chrome come back to me trust me this is very very important implied volatility is greater than realized volatility about 80 to 85 percent of the time this is not my opinion this is not just some theoretical construct this has been shown with empirical support over and over and over again by our very research team at tastytrade you guys can google you know market measures tastytrade realized volatility and you will find you know 8 15 25 different segments that the team has done over the years showing this fact now you might naturally be asking what does that even mean well here's what that means implied volatility is the volatility that is forecasted out into the future right is it is the volatility that the market is predicting and approximating right now because we can't possibly know the future right nobody can know with certainty what's going to happen but then when the market actually moves and when that time frame actually does happen we can actually look back and we could say okay the realized volatility for that period the last 30 days the last 45 days whatever the realized volatility was actually x like we now know what the realized volatility was it was x and what we have shown is the implied volatility that is priced by the black shells option pricing model is routinely greater than the realized volatility that actually happens in the marketplace now what does that actually mean if the market could go back and reprice the options knowing what it knows now it effectively means that it would have priced the options lower than it actually did because remember options are priced based on implied volatility not realized volatility because it can't possibly know what can't be known right so it has to price the options based on some forecast based on some implied value that's the implied volatility but if the market could go back and say you know we really kind of botched those chipotle options 45 days ago we sold them for ten dollars we should have actually only sold them for nine dollars or eight dollars or eight dollars and 75 cents or something like that right that is effectively what we're talking about here implied volatility realized volatility the relationship between the two is implied volatility is routinely greater than realized volatility so that brings us to step number three do you want to be long or short options so let's revisit this idea earlier you know nine minutes ago you guys were like all right jim that's a trick question man i'm not gonna fall for it well let's open that up again and let's kind of see if some if some things haven't changed if we think of an options contract as an orange right so i love to use the illustration of an orange for those of you that have you know that are checking out the crash course coming over from from theory to practice my flagship program here on tastytrade that will be back in october once this crash course is concluded you guys know that i love to use the orange as my illustration so let's say that you're an orange farmer and let's say that you manufacture oranges and you just sell them to whoever wants to buy your oranges here's basically what this idea is telling us the market value the true value of your orange is a dollar let's say one dollar per navel but the pricing dynamics of the orange market are such that the oranges actually sell for a dollar ten they don't sell for a dollar they don't sell for their for their true value they actually sell for a little extra there's a little kicker on top of that there's a little you know something on the top of those oranges so if you want to sell those oranges you can sell them for a dollar ten when you actually should be able to only sell them for a dollar so you can decide again you can decide am i gonna be an orange you know consumer or am i going to be an orange producer if i'm a consumer i'm effectively overpaying for these oranges every single time i buy one right this orange is only worth a dollar i'm paying a dollar 10 for it now of course you know put on the shelf the fact that you may love oranges put on the shelf that you you know daydream about navels right let's leave that aside for the time being you're overpaying for those oranges every single time or you could step on the other side of the orange market and you could sell these oranges to the public that are actually only worth a dollar you can routinely sell them for a dollar ten over and over and over again what we're talking about here bring this back into the context of actual options as that orange analysis was falling apart very quickly with the option contracts it's exactly the same it is no different right when the option contract is out there you can decide do i want to be long or do i want to be short well if you choose to be long yes you have the opportunity for unlimited gains yes you also have limited losses but be aware you are effectively overpaying for that option about 85 percent of the time if on the other hand you decide to sell the option you will be receiving that little extra kicker that little extra something on the top about 85 percent of the time now is it that simple is this all there is to it no of course now we've got 14 days left right so there's a lot more to talk about but this begins to put some of the things that we've talked about together in a way that at least my hope is is starting to make a little bit of sense so tomorrow what we're gonna do is we're gonna get into episode number four and we're gonna tackle profit direction and probability and here's all i've got to say about that you guys better buckle up and drink your electrolytes because it is going to be something so man that's all i have for you guys today you guys can always email me if you have any questions whatsoever just jay schultz at tastytrade.com you can hit me up on twitter i'm at jshultzf3 i would love to connect with you all there as well but stay tuned if you guys are checking us out live we have research specials live coming up right now in the meantime guys trade them small train them heavy and stay generous we'll see you guys tomorrow you

Channel: tastytrade

Views: 23,168

Rating: 4.9312716 out of 5

Keywords: moneyness, option's implied volatility, short options unlimited risk, investing, finance, how to, education, curriculum, course, learn, trading, options, tastytrade, portfolio, learn to trade, stock, basics, put, call, trading strategies, trade management, intro to options, options 101, building blocks, transaction, option contract, shares, buy, sell, profit, option strike price, strike price, long option, short option, black scholes model, intrinsic value, extrinsic value

Id: Dz7W8iPmpm4

Length: 32min 20sec (1940 seconds)

Published: Thu Sep 10 2020