What Makes an Option an Option?
By Bill Johnson
Humorist Artemis Ward once said, “It ain’t so much thing things we don’t know that get us in trouble. It’s the things we know that just ain’t so.”
The options markets are filled with myths and misperceptions that prevent traders from using them to their fullest potential. One of the biggest misconceptions is that of cheap and expensive options. If you ask most traders, they’ll tell you that a cheap option is any that cost three dollars or less. While an expensive option cost more. In other words, they’ll have an arbitrary line in the sand to differentiate between cheap and expensive options.
However, professional traders know that it’s the extrinsic value, or the time value, that makes an option an option. If you have an option that’s made up entirely of intrinsic value, it’s not even an option – it’s stock. For instance, let’s say the underlying stock is trading for $120. If the $100 call is trading for $20, it’s entirely made up of intrinsic value and no extrinsic value. There’s not a single option in that deal. This is a condition called “parity,” which just means the option is trading equivalently to shares of stock. And if it’s trading just like stock, there’s no option in it. Even though it may look like an expensive option, it’s nothing but cheap shares of stock with a free insurance policy attached.
To see why, let’s say you bought this call while your friend bought shares of stock. If the stock price falls from $120 all the way down to $100 at expiration, your friend loses $20 and so do you. There’s no difference at all. However, if the stock continues to slide, your friend continues to lose while you’re limited to just the $20 loss. Because your losses are limited to $20, it’s as if you have an insurance policy that you didn’t have to pay for. That’s why you’ll rarely find options trading at parity unless you’re really close to expiration.
However, let’s say this $100 call was trading for $21 rather than $20. Now there’s $20 of intrinsic value and one dollar’s worth of extrinsic value. How much is this option?
Most new traders will say it’s a $21 option. A professional trader will tell you it’s a one-dollar option because that’s the amount you’re paying for the insurance policy. It’s this one-dollar value that will separate you and your friend’s performances. For instance, if the stock falls to $100, your friend loses $20 – but you’ll lose $21. You’re worse off by one dollar because that’s what you paid for the “option” or the right to walk away from the deal. In other words, you’re not required to buy the shares of stock, but your friend already committed to it.
If the stock’s price continues to slide below $100, your friend continues to lose, but you’ll limit your losses to $21. It’s the one-dollar extrinsic value that you paid for the “insurance” policy.
Understanding the art and science of options trading is necessary for success, and the interplay between intrinsic and extrinsic values is a great start. Most traders know the relationships, but if you look closer, they may know things that just ain’t so.
Good Investing!
Bill Johnson, Steve Bigalow
and The Candlestick Forum Team
P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.
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