When studying option trading basics, a critical formula is:
Option premium = intrinsic value + time value (or extrinsic value)
This past week I hosted a seminar in New York and there were many inquiries regarding the difference between intrinsic and extrinsic value so I felt a blog article would be appropriate.
There are three types of strike prices as they relate to the stock price:
- At-the-money (ATM)
- In-the-money (ITM)
- Out-of-the-money (OTM)
The ATM strike is when the strike price and current market value are the same. An example would be when you buy a stock for $50 and sell the $50 call option.
The ITM strike is when the strike price is less than the current market value of the stock. An example would be when you buy a stock for $56 and sell the $50 call option.
The OTM strike is when the strike price is higher than the current market value of the stock. An example would be when you buy a stock for $48 and sell the $50 call option.
Of these three types of strike prices only the ITM strike has intrinsic or inherent value. In the example above, if we sold the $50 call when the stock was trading @ $56, the option buyer could exercise that option, buy it from us @ $50 and sell it at market for $56 generating a $6 profit. In this case the intrinsic or inherent value is $6. The ATM and OTM strikes have no intrinsic value so those options consist only of time value or extrinsic value. Let me give some examples:
ATM: Buy a stock for $50 and sell the $50 call for $1.50. The premium is ALL time value (our initial profit) and represents a 3% initial return ($1.50/$50).
ITM: Buy a stock for $56 and sell the $50 call for $8. The premium breakdown is as follows:
Option premium ($8) = Intrinsic value ($6) + time value ($2)
Our initial profit is NOT $8 because we will be losing $6 on the sale of the shares. Therefore, when calculating our initial profit for an ITM strike, we deduct the intrinsic value from the premium and the resulting time value is our real initial profit, in this case $2.
OTM: Buy a stock for $48 and sell the $50 call for $1.20. The premium is ALL time value as in the ATM example. In this case, $1.20 represents a 2.5% initial return ($1.20/$48).
***Do not include intrinsic value when calculating your initial option returns. For those of you who have access to the Ellman Calculator, these calculations will be automatically done for you after entering the information from the options chain.
Pros and cons of each strike type:
- Generates the highest initial option return
- No upside potential from share appreciation
- No downside protection of the option profit (time value)
- Generates a lower initial return than ATM strikes
- No upside potential from share appreciation
- Provides protection of the option initial profit from the current market value down to the strike price ($6 of protection from the above ITM example)
- Generates a lower initial option return than the ATM strike
- No downside protection of the option initial profit
- Does provide upside potential for share appreciation from the current market value up to the strike price sold ($2 per share in the above OTM example.
I use ATM and OTM strikes when I am bullish about the stock and overall market conditions. I favor ITM strikes when I’m bearish about the overall market or when the technicals of the stock are mixed. Strikes can be “laddered” in most market conditions where you select a mix of strike types. The mix can be an equal number of each or favoring one type depending on market assessment and your personal risk-tolerance. More conservative investors will favor ITM strikes.
Real life example: ASNA:
Note the following: ITM $20 strike generates $1.55 (yellow) ATM (near the money) $21 strike generates $0.95 (green) OTM $22 strike generates $0.55 (purple) *These are all per share stats. Multiply by 100 to get per contract stats. Next we feed this information into the single or multiple tabs of The Ellman Calculator (blue cells) and the results are shown below:
Note the following:
- The $20, ITM strike generates an initial 3.5% return with 4.1% protection OF THAT PROFIT (yellow)
- The $21 ATM (near-the-money) strike generates the highest initial return of 4.6% but very little upside and no downside protection of that profit (green)
- The $22 OTM strike generates a 2.6% initial return with another 5.5% upside potential if the share appreciates higher. This represents a potential 8.1%, 5-week return (purple)
Option premium consists of intrinsic value (ITM strikes only) + time (extrinsic) value. Only the time value represents our initial profit. Understanding the pros and cons of each strike type and basing our selections on chart technicals as well as overall market assessment will allow us to raise our profit returns to the highest possible levels.
Market tone: Here are this week’s reports:
- The trade deficit increased by $6.4 billion due to higher imports; exports held steady
- Consumer credit rose $21.4 billion in March twice analysts expectations
- The Producer Price index (PPI) dropped by 0.2% in April, the largest decline since 10/2011 mainly due to a decrease in energy prices
- Initial jobless claims for the week ending May 5th was 367,000, slightly less than the 370,000 the analysts were expecting
For the week, the S&P 500 declined by 1.1%, for a year-to-date return of 8.4%, including dividends.
IBD: Market in correction
BCI: Cautiously bullish on our economy, concerned about global issues impacting our markets, and selling predominantly in-the-money strikes.