Date: 2/10/2023
Author: Chris Hood
You’re a trader.
So you know just how fast options can reprice.
The underlying stock movement combined with volatility means that contracts reprice quickly.
Just think of the last time you decided to make a trade, enter your price, and just couldn’t get filled because your timing was off.
It’s happened to everyone.
If I’m selling, as with a credit spread or iron condor, I want them pricey. That’s money in my pocket.
High prices mean more reward for my risk.
On the other hand, if I’m buying a call, put, or debit spread I don’t want to pay too much.
Lots of people will tell you not to overpay, but there’s very little I’ve seen written about what it actually means.
Here are some basic guidelines to help you.
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First, let me review intrinsic versus extrinsic value on an options contract.
The intrinsic value is simply the difference between the strike price and the current stock price. So if a stock trades at $100.00 and I buy a $95.00 strike put then the intrinsic value is $5.00.
Consider that if I decided I wanted those shares I could exercise that option and get them at $95.00.
That’s where intrinsic value comes from.
Consider how much cheaper out-of-the-money options are. If a stock trades at $100.00 and I own the $110.00 strike put then it has no intrinsic value.
No one in their right mind would exercise it.
Who wants to pay more for shares than they could buy them for on the open market?
Now for the extrinsic value.
If you buy or sell an option with 60 days until expiration there’s a lot that can happen over those trading days.
I pay for that time value (theta).
This is why options with more time to expiration cost more.
As I write this MSFT closed at $263.62.
I could get the 260 strike call for the 17th of Feb, 2023 for just $7.60. On the other hand, if I buy the same strike for the 24th of March I’d pay about 14.30.
This value bleeds away as the expiration date closes in.
Finally, there’s volatility.
When volatility increases so do option prices. Whether the market, in general, is volatile (rise in VIX), or the stock itself has a high IV rank then you’ll pay more.
The sensitivity of an option to volatility is known as vega.
So now that we’ve had a bit of a refresher, keep this in mind when evaluating your options prices.
Out-of-the-money options are always cheap so we’ll leave those out.
If you’re buying an in-the-money call or put, expensive means the extrinsic value is greater than 1/3 of the total option price.
You can find this information on your options chain.
When a stock is moving up, call options are expensive and puts are cheap. And when it’s dropping, the reverse is true.
This is why it’s critical to get in as early as possible if you want to make the most profit.
Remember every extra cent is one dollar.
Don’t cut yourself short.
Cheers,
Chris Hood
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