S&C Magazine Current Contents Q & A Explore Your Options INTRINSICALLY BETTER?
INTRINSICALLY BETTER?
- Details
- Parent Category: Q & A
- Category: Explore Your Options
- Written by Tom Gentile
Which is considered better to own, intrinsic or extrinsic premium?
That’s a broad question with no absolute answer, though some may suggest that traders refrain from owning extrinsic premium. As option traders, we should recognize that all extrinsic or time value eventually drops to zero. At expiration, all that’s left is real intrinsic value or the option has no worth whatsoever.
More important, having contract value left in the form of intrinsic premium at expiration isn’t the same as making a guaranteed profit. The reality is, you can buy 100% intrinsic value of, say, $5.00 in a deep call or put contract and end up with intrinsic value of $1.00 at expiration, or maybe nothing at all if the contract goes completely out-of-the money.
A trader’s individual style will play a role in determining whether to go deeper in-the-money with more intrinsic value at risk. Those seeking pure directional bets, where the delta approaches 99 and mimics stock, make up this stratum of positioning. But the further out in time one goes, the more difficult it is to secure a deep option with liquidity and the more it makes sense to buy, versus simple stock ownership.
Conversely, a trader can use at-the-money or out-of-the-money contracts risking 100% in time decay or maybe an option that maintains a ratio of both intrinsic and extrinsic value. The upside of using extrinsic premium is that for the same dollars at risk, the trader can obtain more contracts than with deeper intrinsic positioning. If conditions prove beneficial, returns can eclipse those produced from a smaller contract size in deeper options if the move in shares is strong enough.
In making a more informed choice about purchasing options, traders should know their greeks and recognize which of those risks he or she feels most confident with at any given time. Are you really a stock (directional) trader and comfortable with delta being your profit & loss bottom line? What’s your time commitment? Intermediate-term traders have more of a reason to use out-of-the-money contracts with confidence, as time decay (theta) is less an issue. However, those same traders should be secure in the attached and larger volatility risk (vega) per point that’s integral in shaping the extrinsic value of those contracts.
Ultimately, we can’t tell you which is right for the individual trader. But based on market conditions and your preferences for the greeks at any given time, learning to shift gears between intrinsic and extrinsic positioning and making use of spreads makes sense to us and possibly more dollars to your bottom line.
