2018issue C0142
Constructing option strikes from intrinsic and time premium
Strike selection begins by splitting each listed premium into intrinsic value and time premium, then matching that mix to the intended role of the position.
- Intrinsic value is immediate exercise value. Extrinsic value, also called time premium, is the quoted price minus that amount.
- A lower-strike call can be in-the-money with mostly intrinsic value, while a higher-strike call on the same underlying can be out-of-the-money and all time premium.
- The further in-the-money a contract already is, the higher its price and the higher the chance it expires in-the-money. Strikes nearer the money typically draw more volume and a more balanced reward-risk tradeoff.
- There is no single correct strike. The first construction filter is the intended role of the position, not the length of the listed chain.
Split the premium first
Intrinsic value is what an option would be worth if it expired immediately, based only on the gap between the underlying price and the strike. Extrinsic value, also called time premium, is the remainder of the quoted price after that intrinsic amount is removed.
Strike selection treats that split as the working description of every listed contract: some of the premium is already exercise value, and the rest is time premium.
Two listed calls, two different mixes
A call struck at 20 and priced at 6 while the underlying trades at 25 is in-the-money, with intrinsic value of 5 and extrinsic value of 1.
A call struck at 30 and priced at 1 while the underlying trades at 29 is out-of-the-money, so intrinsic value is zero and the entire 1 of premium is extrinsic.
How in-the-money and out-of-the-money are assigned
Calls with strikes below the underlying are in-the-money. Calls with strikes above it are out-of-the-money. The in-the-money and out-of-the-money mapping is reversed for puts.
A put is in-the-money when its strike sits above the underlying, so some exercise value is already present. A put is out-of-the-money when its strike sits below the underlying, so intrinsic value is zero.
What moneyness changes in the book
The further in-the-money an option already is, the higher the chance it expires in-the-money relative to at-the-money or out-of-the-money contracts, and the higher its price.
Strikes nearer the money typically draw more trading volume and a more balanced tradeoff between reward and risk than strikes far from the money.
Deep, near, and cheap out-of-the-money roles
Deep in-the-money calls usually embed the least time premium and can move nearly point-for-point with the shares at a lower cash outlay than buying the stock. They are also the most expensive listed contracts and may trade more thinly with wider bid-ask spreads.
Cheap out-of-the-money contracts carry no exercise value, so the whole premium is time premium. Nearer strikes sit between those two mixes and typically offer the fuller volume and more balanced reward-risk tradeoff noted above.
There is no single correct strike. The first construction filter is the intended role of the position rather than the length of the listed chain.
All readings on this track · 10 readings
- 1998Strike selection from a return distribution and implied volatility
- 2004Constructing an index-options overlay with dividend premiums and open interest
- 2005Implied volatility and price divergence as a sentiment regime filter
- 2007Ranking short options by premium, margin, time, and delta
- 2008Bull put spread construction under elevated implied volatility
- 2008Net time-value ranking for conversion spreads
- 2008Out-of-the-money commodity credit spreads in a volatility regime
- 2012Far-spot option-elasticity and percent-theta limits
- 2012Weekly debit spreads and volatility regime matching
- 2018Constructing option strikes from intrinsic and time premium