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What are options intrinsic and extrinsic values? - YouTube
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there can be dozens or even hundreds of
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different options to choose from for
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each underlying security
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so how does one choose in order to
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answer that question
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it's best to understand how option
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pricing works an options price is the
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sum of two components
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its intrinsic value and its extrinsic
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value
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which is also referred to as time value
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intrinsic value is simply the dollar
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amount that the option is in the money
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or itm or what it would be worth at
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expiration when time value is zero
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out of the money otm options have no
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intrinsic value
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so let's say you have a call option with
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a strike price of fifty dollars
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if the underlying stock is currently
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trading at fifty five dollars
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the option would be five dollars in the
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money that's its intrinsic value
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however when you look up the option you
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notice it's currently priced at seven
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dollars
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this additional two dollars is its
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extrinsic value
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extrinsic value is made up of two
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components as well
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implied volatility and days to
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expiration or dte
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volatility is influenced by many factors
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including market uncertainty
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and significant company news such as an
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upcoming earnings announcement
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just to name a couple and days to
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expiration while that one's fairly
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straightforward
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the longer the dte the higher the time
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value
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as there is more time for the option
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price to change however
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it's important to understand that time
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value decreases exponentially
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as the option's expiration date draws
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closer so
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if you hold an option position and its
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underlying stock hasn't changed in value
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you'll notice the option's value
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dropping because time value is eroding
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out of the money options are much more
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sensitive to decreasing time value than
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in the money options
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taken together intrinsic and extrinsic
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value make up an option's price
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unfortunately calculating it isn't a
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cakewalk
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it can be estimated using a complicated
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formula called the black scholes model
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which is beyond the scope of this
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introductory lesson but let's look at
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another option pricing example
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using a chart to see how this
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relationship works in broad strokes
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along the x-axis we have the options
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days to expiration
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and along the y-axis the option's total
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value
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let's say we have a call option with a
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strike price of ninety dollars and the
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underlying stock
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is currently trading at one hundred
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dollars per share the first bar on the
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left shows the options intrinsic value
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of ten dollars
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the difference between the stock's
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current price and the strike price
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along with its extrinsic value which is
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made up of its 40 days to expiration
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and its volatility of 30 percent
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now let's say the stock price rises
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slightly to 102
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over the next 10 days and its volatility
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remains the same
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you can see on the next bar over on the
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chart that the option's intrinsic value
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rose slightly to 12
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however the extrinsic value is lower
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because we now have 30 days to
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expiration
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and volatility remain the same notice
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that the total value of the option did
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not change
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this is because the increase in
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intrinsic value was offset by the
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decrease in extrinsic value
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now let's say the stock slips to 100 per
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share
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over the following 15 days and its
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volatility climbs to 45
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on the third bar in our chart the
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option's intrinsic value is back down to
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10
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and its extrinsic value is unchanged
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with the decrease in days to expiration
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offset by the higher volatility on major
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company news
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yet the total value of the option has
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gone down
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now let's look at the last bar in our
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chart the stock is up to 105 dollars
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following the news announcement so the
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option's intrinsic value
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pops to 15 however volatility is now
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down to twenty percent
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and there are only five days to
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expiration see how the total value of
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the option is less than what we started
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with despite the stock being up
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five dollars the increase in intrinsic
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value was not enough to make up for the
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loss of time
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and the drop in volatility the lesson
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here
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an option trade may not be profitable
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even if the underlying moves in a
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trader's favor
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a common real life example of this
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occurs around earnings announcements
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volatility is typically higher than
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average prior to the announcement
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which can inflate option premiums then
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after the announcement is made
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volatility typically drops back down to
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normal levels
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this is called a volatility crush now
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what we've walked through here is a very
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simple example of how an options price
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can fluctuate
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based on changes to the underlying price
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volatility
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and time so how can you grasp the impact
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that intrinsic and extrinsic values
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have on an option's price for that let's
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look at an option chain the deeper in
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the money we go for both calls and puts
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the higher their intrinsic value becomes
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and the more days there are to
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expiration the greater the extrinsic
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value
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all things being equal an option that
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expires in 30 days
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has a lower premium than an option that
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expires in 120 days
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when they both have the same strike
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price and underlying stock
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and that's intrinsic and extrinsic value
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in a nutshell
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understanding these components can help
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traders make educated guesses
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as to how an options price may behave
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this is especially helpful when
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selecting strike prices and expiration
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dates for new option trades
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as you'll soon discover in our next
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lesson
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