Become a better investor
Lesson in Course: Derivatives and options (beginner, 5min )
I've learned than options represent a promise between two investors. What makes this promise valuable?
When was the last time we've seen a promotional offer?
All promotional offers allow us to save or earn $X within a period of time. Once the promotion expires, the value promised is gone. Options contracts are very similar to promotional offers because there is a limited time associated with the option contract. Investors and traders have understood the temporal difference between options and stocks and have put an additional value on the time within an option contract. Let's step through what adds to an option's value.
The three takeaways for this lesson are:
The bulk of an option's value is tied to the promise of the contract. For the buyer of a call option, it's the promise to be able to buy 100 shares of a stock at the strike price. For the buyer of a put option, that promise is to be able to sell stock 100 shares of a stock at the strike price. If we return to the Uber Eats coupon example above, we can see that this is actually very similar to a call option. The coupon is allowing us to buy let's say $60 worth of food for $35. This promise has $25 of monetary value to us if we choose to use it.
The intrinsic value is the economic value of the promise of an option contract.
The value is determined by the relationship between the promised price and the actual price of the underlying stock. The promised price is known as the strike price. As we learn more about options, we'll see how to calculate the intrinsic value using the strike price.
Can the intrinsic value ever be negative?
No, the intrinsic value of an option can never be negative because the buyer of a stock option is not required to go through with a bad deal. Let's revisit the example above and assume the coupon is only good for $25 worth of food while still costing us $35 to use. With the current deal, we would lose money if we tried to use the coupon. By simply choosing not to use the coupon, we avoid potential losses.
Apart from the change in price, there's also the value in the time of the offer itself. Let's imagine a Chick-fil-A opened up near us and we are waiting for it to appear on Uber Eats.
A promotional offer from Uber Eats for 10 days has less of a chance to help us get a discount for chicken nuggets than a promotional offer for 120 days. To us, the 120-day offer is a better one even though both provide the same $25 discount. Would we be even tempted to want to pay $5 to extend the 10-day promotion to a 120-day discount? I bet we know some folks who would.
The extrinsic value of an option is the value assigned to an options contract that is based on factors outside of the economics of the underlying promise.
While extrinsic value can be based on a few factors, time is almost always one of the biggest factors. Let's step through an example that puts it all together.
We can see that in the example above, an option contract has a value of $17 per share. Right after we purchased the option, the majority of the value ($12) is actually in extrinsic value compared to our intrinsic value of $5. A trend we will see is that over time, as the promise gets closer to expiration, the extrinsic value starts to shrink. We'll learn more about why in future lessons.
A simple trick to remember the difference between intrinsic value and extrinsic value is the statement, "I promise time is extra." Intrinsic is the promise and it starts with "I." The extra value of time is extrinsic. Clearly understanding the difference between the two values will help inform us on which options can be right for us. Do we value more the current promise? Or do we value what could be?