Ratio Spreads and Extrinsic Value
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
For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.
Trade with a better broker, open a tastytrade account today. tastylive, Inc. and tastytrade, Inc. are separate but affiliated companies.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.
© copyright 2013 - 2024 tastylive, Inc. All Rights Reserved. Applicable portions of the Terms of Use on tastylive.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastylive’s podcasts as necessary to view for personal use. tastylive was previously known as tastytrade, Inc. tastylive is a trademark/servicemark owned by tastylive, Inc.