Option time value volatility
Once you understand how extrinsic value interacts with intrinsic and time value of an option, you are better suited to select underlying stocks most suitable for your strategy, and to manage stock and option risks more effectively. The intrinsic value of an option is restricted to the number of points it is in the money. The time value is the portion of the premium associated with time remaining to expiration. Time value declines as expiration approaches, with little or no time value remaining at the time of expiration.
Extrinsic value is the portion of option premium that increases or decreases due to volatility and market risk, and which may offset changes in intrinsic value caused by movement of the underlying stock.
The proximity of current price to the strike is essential in judging the relative value and volatility of an option. The time value of an option is entirely predictable. Time value premium declines at an accelerating rate, with most time decay occurring in the last one to two months before expiration.
This occurs on a predictable curve. Intrinsic value is also predictable and easily followed. It is worth one point for every point the option is in the money. The third type of premium, extrinsic value, increases or decreases when the underlying stock changes and when the distance between current value of stock and strike of the option get closer together. As a symptom of volatility, extrinsic value may be greater for highly volatile underlying stock, and lower for less volatile stocks.
Extrinsic value is the only classification of option premium that is unpredictable. There are two types, historic and implied. Historic volatility refers to stocks, mutual fund shares, and other equity accounts and the degree and rate of price changes. A stock with a broad trading range and a tendency for price to move rapidly up and down is highly volatile; making is less predictable than a more stable, low-volatility stock.
As a rule, stocks with higher than average historic volatility also tend to have associated options with higher premium levels. As the price varies based on volatility, it is also a symptom of changing risk levels. This brings up the second type, known as the implied volatility of options.
In studying the cause and effect of option premium levels, it often occurs that expected movement in the underlying stock may be factored into option premium values before the move occurs. As a consequence, option premium value and specifically, extrinsic value at times is unresponsive to movement in the underlying stock, even when the option is in the money.
The premium value may even move in a direction opposite that of the underlying. Equally important, options with a long time to expiration, notably out-of-the-money contracts, tend to be very unresponsive to underlying price movement. The two terms are used interchangeably in this article.
As the stock price moves closer to a strike price, the options at that strike both the put and the call gain extrinsic value. If the stock price moves away from the strike, both the put and the call at that strike will lose extrinsic value.
The numbers in the blue outlined boxes above show the amount of Extrinsic Value in each option. The blue bar charts show these amounts graphically. Wider bars correspond to larger amounts of extrinsic value. Being the at-the-money strike price is not a permanent condition for any option. As the stock price changes, it moves past one strike prices after another. Think of the stock price as sliding up and down the option chain. Whichever strike it is closest to at any point in time is, at that moment, the ATM strike.
The options at that strike will have the greatest time value. As the stock moves along on its way leaving that strike behind, the options at that strike lose time value again.