Ratio Spreads and Extrinsic Value
Nov 14, 2023
One of core concepts you learn early on in your options education is that at-the-money (ATM) strikes always carry the most extrinsic value. While this nugget might seem to be nothing more than a random line barely worthy of memorization, it has particularly important implications in your trading.
Case in point, when you sell an out-of-the-money (OTM) option, put on a short straddle, or even manage a ratio spread
Selling OTM options is always a great foundation for any portfolio of derivatives. Given the fact there is always a buffer between the strike price of the option contract and where the stock price is, short OTM options always produce high probability trades that put time on the side of the trader. A win-win proposition by any measure.
Still, it’s important to recognize the role that extrinsic value will play in a short OTM position. Given that extrinsic value is the highest ATM, if the stock begins to move towards the strike shortly after you put the trade on, that means its extrinsic value will rise.
If you sell an option, and its extrinsic value quickly begins rising, then your position will show a loss. Being short an option, you want to buy the option back for less than you sold it for on entry. Therefore, this increase in extrinsic value will work against your profit goals for the position.
Not only do ATM strikes have the most extrinsic value, but they cling on to that extrinsic value the longest—longer than OTM options or even in-the-money (ITM) options. Therefore, when you enter a strategy like a short straddle (a strategy in which you sell the ATM put and the ATM call), you are maximizing your extrinsic value collected on entry. But all that added extrinsic value comes at a cost.
These options will decay very slowly. Provided the stock stays around your short strikes and doesn’t move much, you will notice the extrinsic value in your position is quite sticky. Therefore, to combat this slow decay, we typically like to manage our short straddles more aggressively than other strategies—at 25% of maximum profit.
Like the way extrinsic value rises when the stock moves towards your short OTM strike, Ratio Spreads will show losses if the short strike gets hit too quickly. While with a Ratio Spread you do achieve maximum profitability if you pin the short strike, this is only the case if you pin the strike at expiration and extrinsic value is zero. Prior to expiration, the short strike being hit will always cause the options' extrinsic value to rise, for all the reasons we mentioned earlier. If this happens too early in the life of the trade, it will most likely lead to carrying a negative profit/loss on the trade.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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