A common question people ask me when they first get introduced to options: how do I choose the right option contract?
Although there isn’t always a clear cut answer.
By understanding the mechanics of how options are priced, you’ll be able to select the right contract according to your expectations.
And that’s what my goal for you is, after reading this.
I’m going to show you the quickest way to discover if you’re getting ripped off or not…and what you can do to overcome it.
All option contracts are made up of three components: time until expiration, strike price selection, and implied volatility.
Yes, there are others, but they aren’t relevant for the moment.
Imagine that we are at expiration with a call option. Implied volatility and time decay would be zero.
The only thing left would be the strike price or said differently – the distance between the stock’s current price and the strike price.
Let’s say I held a $490 call option on Apple. At expiration, the stock closes at $500.
If I executed that contract, I would be able to buy 100 shares of Apple at $490 and then immediately sell them at $500, the prevailing market price.
That means the options contracts have $10 worth of intrinsic value – $500 – $490 = $10.
Now, let’s say everything is the same but we’re two weeks from expiration.
That same $10 call option may now sell for $14.
The extra $4 in premium is what’s known as extrinsic value. This is the portion of the option premium (price) that disappears by expiration.
In vs out-of-the-money
First, we need to understand how the strike price relative to the current stock price changes intrinsic and extrinsic value.
Out-of-the-money means that you have a put strike below the current stock price or a call strike above the current stock price.
In the money is when the put strike price is above the current stock price or a call strike that is below the current stock price.
At-the-money is when the stock price and option strike price match.
Options that are at-the-money have the HIGHEST extrinsic value possible and no intrinsic value.
As you move further away from the current stock price, extrinsic value declines.
Moving further in-the-money increases the intrinsic value and decrease extrinsic value.
Here’s a graph of a call option to help you visualize what’s happening.
Call option strike price graph
In the graph, the total value of the option is the outside line that slopes up and to the right.
What this says is as you go farther into the money, the more expensive an option gets. But, the deeper you go in-the-money, the more it’s made up of intrinsic value.
And intrinsic value doesn’t decay with time as you’ll see shortly.
Time and extrinsic value
Now, I want to go over the relationship time until expiration and extrinsic value.
Here’s a graph to help our discussion.
Time decay for an option works differently the further out-of-the-money you go vs the further in-the-money you are.
When you’re in-the-money time decay becomes very linear as opposed to exponential (IE curved to speed up).
Creating an advantage
How might I use that to my advantage?
Let’s say I want a trade with a lot of directional exposure but minimizing extrinsic decay.
Take what we’ve discussed and form a strategy.
If I want to bet on the stock going up I would buy a call option.
To get more exposure to directional movements, I would pick an expiration that’s nearer rather than further away.
Then, to cut down on the extrinsic value, I’d pick an option contract that’s further in-the-money.
Now, this would make it more expensive compared to one out-of-the-money.
But, I don’t have to worry as much about the time decay.
However, not everything is roses here.
If the stock turns against me and moves in the wrong direction, my in-the-money option can become out-of-the-money.
That means if I get to expiration, I lose everything.
So, it’s a balance.
Practice makes…better decisions
Nothing is guaranteed in trading. Perfection isn’t attainable.
What we can do is aim for making the best decisions possible.
That’s why my LottoX service combines trade alerts, a streaming portfolio, as well as live weekly training with tons of educational content.
I aim to teach you the very same skills that I use to trade the market for a living every day.
Use this as a stepping stone on your path to becoming a better trader.