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Option Moneyness (ITM, OTM & ATM) - Options Pricing - Options Trading For Beginners - YouTube
Channel: Option Alpha
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Hey everyone, this is Kirk here again at OptionAlpa.com
and in this video we're going to talk about
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option moneyness or the difference between
in the money, out of the money and at the
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money options.
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We're also going to talk a little bit about
extrinsic versus intrinsic value.
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Options are generally classified by traders
into three very distinct categories, in the
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money options, ITM, at the money options,
ATM and out of the money options, or OTM.
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These are also used to quickly reference difference
options when building complex option strategies.
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You'll often see, especially in our ultimate
strategy guide and in all of the different
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video tutorials and modules we have at Option
Alpha that we will more often than not reference
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buying an in the money option and selling
an out of the money or buying an at the money,
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selling at the money or whatever the case
is.
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We use these a lot as traders to quickly talk
about a section or a group of trades based
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on where they are in the option pricing table.
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Let's go through an example here with a simple
call option.
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This is a call option pay off diagram, probably
one you've seen before in this track as we've
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been doing other videos.
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For call options there's a lot of different
moneyness related to where the stock price
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is because again, everything in moneyness
is determined based on the strike price and
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its relationship to the stock price.
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In this case if we have a 40 strike call option,
that's where the payoff diagram pivots, this
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is a 40 strike call option.
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The option would be in the money is the stock
price was higher than the strike price.
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If the strike price or if the stock price
was higher than the strike price, then this
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option would be in the money.
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In this case if the stock price was $50 and
we had the 40 strike options, we would be
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in the money.
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When I always think of in the money versus
out of the money, in the money means am I
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making money or am I not, right?
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That's the way I always distinguish it is
if I'm in the money, I'm making money, meaning
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the stock price is higher than my strike price.
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For an option that is at the money, then the
stock price is going to be equal to or very
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similar to the strike price.
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An at the money option in this example would
be a 40 strike call when the stock is trading
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at $40 or something very, very close to 40.
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An out of the money option would be when the
stock price is dramatically below the option
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strike price.
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Again, these are just for a call option.
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In this case this would be when the stock
price is at $30 and we are buying an out of
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the money 40 strike call where the strike
price is above the current stock price.
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Again, the way I always think about it is
an out of the money because I'm not making
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money yet.
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My option isn't in the money at expiration.
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It's not making money yet.
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Another quick way to look at it is visually
on a chart.
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In this case if we have the current stock
price at let's say $45 which is the difference
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here in these shaded areas.
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If we see the stock trading from 45 down to
40, okay, then that strike price is in the
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money because the strike price down here at
40 with the stock trading at 45 means that
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we've got a $5 difference between our strike
price and where the stock is trading at $45.
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That strike price at 40 is in the money.
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It's making money right now.
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We can buy stock at 40 and sell it back at
45.
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If later on we look at a strike price of $45
which is exactly where the stock is trading
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right now and exactly where the strike price
is, that strike price is at the money.
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It's basically the strike price exactly where
the stock is trading right at the moment.
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A strike price that's out of the money would
be an example of a strike price around $50.
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Again, kind of using the same numbers that
we used before.
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If the stock is currently trading at 45 and
we buy a 50 strike call option, then that
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strike is out of the money.
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It's above where the market is trading currently.
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We need the stock to rally before we actually
make any money at expiration.
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All right, so let's flip things over here
and look at an example with a put option.
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Now a put option is going to be pretty much
everything just in reverse.
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A put option that's in the money, meaning
they're making money, is when the stock price
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is now below where the strike price is.
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In this case if we have the 40 strike put
options, we'd be in the money if the current
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stock price was $30 and if we had the 40 strike
put options, those would be in the money because
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they'd be making money based on the current
stock price of $30.
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If we had an at the money put option, obviously
the strike price and the stock price would
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be very similar or the same.
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This would be a $40 strike price and a $40
stock price.
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If we had an out of the money put option,
that means that the stock price is much higher
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than the current strike price.
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If the current stock price was $50 and we
wanted to trade the 40 strike puts, those
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40 strike put options would be out of the
money or below where the stock is trading
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right now.
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Okay?
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Here's the thing, before we get into some
examples on my live thinkers from platform,
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pricing for options is basically put into
two components.
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There's really two main components that make
up pricing.
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There's intrinsic value and then there's extrinsic
or time value for an option contract.
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I'm going to show you how we can actually
see the differences between those for every
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contract that you want to look at.
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It's important to realize that an option with
intrinsic value is in the money and does have
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value at expiration.
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That's how we determine intrinsic value is
we basically ask ourselves if expiration was
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today could you make money on this option?
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If the answer is yes, then it's an in the
money option.
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If the answer is no, then it's an out of the
money option and usually at the money options
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are either just slightly in or just slightly
out of the money.
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Okay?
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Let's look again at a couple of examples here.
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We're going to go back to our option pricing
table here with DIA.
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We've used this one in a couple other videos
inside of this beginner track here at Option
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Alpha.
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Again, just to refresh your memory, we've
got all of the strike prices right down here
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in the middle and then we've got the call
options on the left hand side and we've got
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the put options on the right hand side.
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Now I've adjusted these actual columns to
show you intrinsic and extrinsic value because
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this is going to help us understand which
options are in the money and which options
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are out of the money.
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Now the first thing we have to realize is
that DIA right now is trading at 176.07.
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Now this is going to move because this is
all live, real-time pricing.
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It's trading at 176.0708, so a couple pennies
above 176.
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Let's start on the call side of the options
pricing table.
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Now it's really cool here because Think Or
Swim does a really good job and most broker
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platforms do, they usually shade any call
options that are in the money.
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They might shade them a different color, but
you can see that really with a call option
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any strike price that is below where the current
stock price is is going to have an option
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that is in the money on the call side.
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Now you can see all of these options, 174s,
then 174.5, 175, et cetera, et cetera.
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These are all in the money right now on the
call side because the options strike price
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is below where the current stock price is.
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You'll notice that the 176.5 call options
are not shaded here and that is because those
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options are just slightly out of the money.
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Those options are just slightly out of the
money.
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The at the money options in this case would
be the 176s, because they are the closest
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to where the stock is trading right now.
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Again, it will never be exactly perfect.
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You'll probably rarely see a stock trade right
out at round number all the time, but it's
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always going to be the strike prices that
are closest to where the stock is trading
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currently.
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In our case with DIA it's the 176 calls inputs.
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That's the at the money strike.
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Now again, on the call side the out of the
money options are the ones that are not shaded.
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These are the ones with strike prices that
are higher than where the stock is currently
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trading right now.
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DIA is trading at 176.
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All of these strike prices are above or higher
than 176.
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That means that all of these options are OTM
or out of the money.
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If we ever talk about selling at out of the
money or buying an out of the money, we're
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talking about these options on the left hand
side.
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If we use the put side now and go over to
the other side of the pricing table you can
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see everything is now in reverse because put
options and call options basically trade in
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reverse, meaning that everything with a strike
price now above where the stock is trading
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are options on the put side that are in the
money.
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They're all shaded yellow here.
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These are all in the money options.
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You'll notice now the 76 option in the put
side is out of the money versus being just
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slightly in the money on the call side.
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Now you can see that that's the difference.
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Again, these, this shading will change as
the value and as the price of the underlying
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stock changes.
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As it goes up and as it goes down most broker
platforms will show you the difference between
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these.
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Again, these options over here, these are
all in the money, ITM.
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These options down here, these are all out
of the money, or OTM on the put side and visa
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versa on the call side.
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Now in both of these categories we have these
extrinsic and intrinsic value.
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Now remember what we said about intrinsic
value.
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Intrinsic value is the value if expiration
were to come today, meaning how much money
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could you make owning these options if expiration
came today and you had no choice but to buy
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and sell the stock as required by the option
contract?
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In this case you look at something like the
176 call options and you can see that the
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intrinsic value is basically the difference
between the current stock price and the strike
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price, that's 176.
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The current stock price is 176.13.
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If the market were to end today and expiration
were to come today, we could theoretically
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buy stock at 176, sell it back at 176.12 or
176.13 and that's where we come up with our
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intrinsic value of 12 cents for this contract.
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Again, this is going to move.
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Intrinsic value is always going to move penny
for penny with where the stock is and it's
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basically going to show you how much money
you could make at expiration if everything
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were to end today.
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Okay?
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Now notice any out of the money options have
no intrinsic value.
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That means you would never exercise your contract
to buy a 176.5 stock and then be able to sell
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it for 176.11.
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You would never buy stock willingly for more
than you could sell it for at the same time.
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That's why you'll see all out of the money
options on both sides have zero intrinsic
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value.
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There's no value to those at expiration.
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That's why they expire worthless at expiration,
because eventually the value of options always
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goes towards intrinsic value.
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That's what happens.
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They go always towards intrinsic value as
they near expiration.
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Now extrinsic value is a combination of time
decay and volatility and a little bit of dividend
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and interest rate pricing for options.
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Extrinsic value shows you the additional value
of that contract based on how much time is
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left and how much volatility is in the market.
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This is where we really start to talk about
our edge in trading because extrinsic value
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can fluctuate very, very fast without the
stock actually moving.
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As implied volatility rises extrinsic value
across the board rises as well.
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All option values rise when implied volatility
rises.
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Just like all option values drop when implied
volatility drops.
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The stock does not have to move.
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In this case it's showing you that let's take
the 176.5 call options here.
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Those options right now are priced between
185 and 190, but all of that value of those
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options is extrinsic value, meaning all of
the value of those contracts right now is
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based on the assumption that there's time
and volatility that those contracts may at
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some point in the future increase in value
to some intrinsic value.
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Okay?
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You'll notice that as you go further and further
out of the money the value of options goes
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down because there's a low likelihood that
those options become in the money.
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Right?
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The options that are close like the 176.5,
those options have a pretty good shot of being
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in the money, meaning there's a pretty good
shot that that DIA trades from 176.15 up to
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and above 176.5.
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There's a less likelihood that it trades up
to 179.
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The value of those options in their extrinsic
value format is much, much lower than the
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176.5 because there's a lower likelihood that
DIA trades up to 179.
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Okay?
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This concept of intrinsic and extrinsic value
is very, very important, especially as we
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talk about how options are priced, how prices
move and how prices fluctuate with different
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changes in the market and now we're starting
to develop hopefully a good solid foundation
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as we move further into track one and kind
of towards the back half of track one in talking
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about option strategies, how to choose those
and options pricing and why our edge is mainly
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surrounded by implied volatility.
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Again, thank you so much for checking out
this video tutorial.
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If you have any comments or feedback please
ask them in the comment section right below.
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If you love this video and you want other
people to see it, please share it online.
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Help spread the word about what we're trying
to do here at Option Alpha.
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Until next time, happy trading.
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