Intrinsic or Extrinsic Value

One point not often discussed is the way in which options are priced.  The quoted option price is in reality the sum of two separate components. These are referred to as the intrinsic and the extrinsic portions of the premium.  I think of these as steak and sizzle respectively.

For example, let's say AAPL has closed at around $395.  The January 390 call has 41 days to expiration and could have been bought for $18.90.  Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.

This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility.

The intrinsic premium is subject to change solely due to changes in the price of the underlying security.  There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.

The situation with the extrinsic premium is quite different.  The value changes not only with time to expiration but also with the constantly changing implied volatility.  It is for this reason that an option trader must be very careful with this extrinsic component.

Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.

Another important concept is that of the "moneyness" of an option.  An individual option can be classified in one of three categories of "moneyness:"

* At-the-money
* In-the-money
* Out-of-the money

At-the-money options by definition consist of a single strike price.  Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.

In our example of AAPL, the at-the-money strike is the 395 strike. The in-the-money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395.  The out-of -the-money strikes consist of all calls above the 395 strike and all puts below the 395 strike.

Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.

The reason for taking the time to discuss in some detail this classification of "moneyness" is that there are important reliable characteristics of each type of option.

 At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium.  In-the-money options have the least amount of extrinsic premium.  Out-of-the-money options consist entirely of extrinsic premium, and therefore only contain sizzle . . . no steak can be found there.

Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different "moneyness" to achieve trades with the best probability of success and the highest risk/reward scenarios.

For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.