Tuesday, February 9, 2010

Extrinsic Value and the Bell Curve Phenomenon

I have to say I was quite overwhelmed with the responses to yesterday's question.

Please folks, don't every one speak up all at once....lol.

Anyways, kudos to Jon for nailing down the answer. Though the SPY ratio spread was positive theta at inception, it has now turned theta negative.

Say what?

As a precursor to understanding how theta can often times flip with various types of option positions, one must first grasp the dynamics of option pricing and more specifically the relationship between extrinsic value and strike prices. One quick side note before we continue our stroll down option theory lane; extrinsic value is often times referred to as time value. Though they can be used synonymously, I prefer the term extrinsic value since time is not the only factor influencing this portion of an options price.

An options premium consists of two parts: intrinsic and extrinsic value. Thus we often use the formula P = IV+ EV. In other words, premium equals intrinsic value plus extrinsic value. While the two big factors that influence extrinsic value are time and implied volatility, strike price also plays a part. Consider the following graphic illustrating the relationship between the amount of extrinsic value in an options premium and strike price.

As you can see if one were to plot the amount of extrinsic value in a series of options expiring in the same month, it produces something similar to a bell curve. The gist of the graphic is extrinsic value peaks in at-the-money options and diminishes as the strikes move further in or out-of-the money. As a result, spreads that involve simultaneously buying and selling options with different strikes in the same month can often see their position theta flip.

Want More? Check out these related posts:
Theta
Gamma vs. Theta
Gamma vs. Theta Part II

4 comments:

greg said...

i'm still unclear as to why in your SPY put ratio spread negative theta is a good thing. I may be wrong, but when one sells options, one hopes that the time value premium will decay quickly so as to make the option less likely to be assigned (all other things being equal). Therefore, a negative theta would imply that there's a lot of time decay. Since in your spread you sold 2 puts & only bought one, negative theta - in this case- means time is on your side?

greg said...

sorry, meant to say, "i'm still unclear as to why in your SPY put ratio spread negative theta is a bad thing."

Tyler Craig said...

Hey Greg,

Thanks for the question- I'll respond in tomorrow's post.

Penny Stock Investing said...

I have never invested in options they are a little beyond me. But penny stocks or stocks under five dollars thats a different matter. Their are stocks like petsmart that traded at 2 dollars a share 11years ago now the stocks almost fifty. Also pricesmart traded at about 7 dollars a share about seven or eight ago now its almost around sixty dollars. Their are many other examples Apple computer traded ar only 5 dollars a share in 1998 now its over 400. These stocks are being held quite a long time generally speaking I would say four to six years would be about right as far as buy and hold go. I have a website where I have been following stocks under five dollars. I generally hold my stocks anywhere form 2 to 6 years.