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Lesson in Course: Derivatives and options (beginner, 8min )

I have learned that investors can value a promise in a few ways. How does the value of our option change when the value of underlying changes?

Eureka!
  • What it's about: An actionable way to start thinking about intrinsic and extrinsic value.
  • Why it's important: Strategies differ for options with different intrinsic values.
  • Key takeaway: At maturity, out-of-the-money and at-the-money options lose all of their value.

Options have the versatility to be used by investors as a way to take on more risk and potentially amplify gains. Or they can be used to protect the value of an investment from the unknown. Regardless of the strategy, options represent contractual rights with monetary value. Let's review what makes up the intrinsic and extrinsic value of options and learn how to follow the money.

Where's the money today?

As we learned in a previous lesson, the intrinsic value represents the value received today by the owner of the contract if both parties fulfill their obligation of the options. Another way to think about the intrinsic value is the difference between the strike price and the current market price of the underlying. By keeping track of the difference, we can begin to follow the money and understand the three different categories used to describe intrinsic value.

IN-THE-MONEY (Hit The Goal)

Options are in-the-money when the difference between the strike price and the underlying price is good for the option holder.

A call option is in-the-money for us when we can buy shares at a discount to what's being sold on the market. The stock price has to be higher than the strike price. A put option is the opposite of a call option and is in-the-money when we can sell shares at a premium to the price offered by the market. In this case, the stock price must be lower than the strike price.

 

As a buyer and owner of stock options, we always want our options to be in-the-money at maturity to maximize our chances for profit. For this reason, in-the-money options generally have the highest option prices.

AT-THE-MONEY (Almost hit the goal)

Options are at-the-money when the price of the underlying stock equals the strike price. 

At-the-money options offer no discount or premiums. In this case, using our options contracts to buy or sell stock results in no difference compared to buying or selling at the market price.

An example of an at-the-money put option is a $9 strike put for $F when the stock price is $9. Regardless if we use the put option contract or sell $F on the open market, we will receive $9 a share for our Ford stock.

OUT-OF-THE-MONEY (Missed the goal)

Options are out-of-the-money when the difference between the strike price and the underlying price is bad for the option holder.

Call options are out-of-the-money when the price of the stock is lower than the strike price. Put options are out-of-the money when the stock is higher than the strike price. Out-of-the-money options represent the current underdog contracts because they aren't favored to win.

A quick example of an out-of-the-money call option is a $780 strike price call for $TSLA when the stock is trading at $720. We would never use the contract to buy shares of $TSLA for $780 when we can just buy them on the market for $720.

 

Being able to identify the intrinsic value is a crucial skill. Can we find all three types of intrinsic value in the example of a call and put option on Robinhood today?

Robinhood option chain

Where's the money tomorrow?

Time is one of the factors that cause option prices to change. An in-the-money option purchased today is not guaranteed to stay in-the-money over the next few weeks or months. Our in-the-money position can become further in-the-money or even out-of-the-money if the stock reverses direction. While it's impossible to reliably predict the future, we can observe some larger trends that can help us avoid simple mistakes.

money flows out of the losers

As the maturity date approaches, out-of-the-money and at-the-money options quickly lose all of their value and the option prices approach $0.

Without any intrinsic value, the option's price is only made up of extrinsic value. As time runs out, this value also goes to $0 because the likelihood of a big change starts diminishing. A simple way to remember this is by revisiting the question above, "How likely is $TSLA to double in price in a few hours compared to a few years?" If we feel like our chances of finishing in-the-money are not good, we shouldn't hold the options to maturity.

Beware! Out-of-the-money trap

The biggest mistake most emerging investors make when using options is to buy cheap out-of-the-money options with short maturity dates.

It's tempting because:

  1. The option prices are among the cheapest
  2. The value of the option can change wildly
  3. The thrill of high stakes gambling

While there is technically nothing wrong with buying out-of-the-money options, not understanding how time impacts these options can result in large losses. As the likelihood to finish in-the-money diminishes, so will the price of the option. While cheap options are very tempting, they are often cheap for a reason. We'll cover how to manage the risk of time or theta decay in future lessons.

 

Actionable ideas

The value in options contracts is largely dependent on changes in the underlying stock price and time. As the contracts get closer to maturity, the extrinsic value decreases until the option price is completely made up of the intrinsic value. Being able to quickly recognize the intrinsic value of our options will help us decide if we want to hold onto an option contract to maturity. This can be the determining factor between a nice payday and walking away empty-handed. If you have a brokerage account that allows you to trade options, can you identify which options are in-the-money as opposed to out-of-the-money?

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