Three Ways to Trade Extrinsic Value at Different Strikes
Three Ways to Trade Extrinsic Value at Different Strikes
Premium options sellers should understand how extrinsic value works across strikes and expiration
- One of the most fundamental relationships in the options market is the inverse relationship between probability of profit and credit collected.
- Extrinsic value is at its peak at the ATM strike—a characteristic that helps when using short straddles or adjusting inverted strangles.
- The ATM strike has the most extrinsic value and the largest extrinsic value difference between the front month and the back month.
The price of an out-of-the-money (OTM) option is entirely extrinsic value, so understanding its nuances across strikes and expiration can be very fruitful for a premium seller.
Here are three key points about extrinsic value that can help your trading:
1. Extrinsic value and moneyness
First, extrinsic value always drops off as you move farther OTM with your strike selection. One of the fundamental relationships of the marketplace is the inverse relationship between credit collected and probability of profit (POP) for an OTM option. If you sell a close to at-the-money (ATM) option, your POP might be on the lower side, but you will collect a greater credit on the trade because the extrinsic value on that option is higher. Similarly, if you move farther OTM, you will be able to boost your POP significantly, but you have to be willing to accept a lower credit because there is less extrinsic value in the OTM strikes. Moneyness and extrinsic value share a reliable relationship.
2. ATM extrinsic value
Second, extrinsic value doesn’t just drop off as you move OTM. It reaches its peak right at the ATM strike. When you move over to the in-the-money (ITM) side of the market, you see extrinsic value dropping off the same way it did on the OTM side. Because extrinsic value is maxed out at the ATM strike, short straddles (selling two ATM strikes) can be powerful strategies, and adjusting an Inverted Strangle by rolling to the ATM strike is often our preferred adjustment for that strategy.
3. Rolling extrinsic value
Third, a common approach to adjusting a short strangle strategy is to roll up or down and out when one side gets tested (the strike gets hit by the stock price). When this happens, if you do indeed choose to roll out in time to the next expiration, you’ll be able to take advantage of the biggest extrinsic value difference between cycles. While cycles with more duration always have more extrinsic value than cycles with less duration, the extrinsic value difference between the two cycles is greatest for the ATM strike. Therefore, if you roll out when one side of a strangle is tested, you’re able to take advantage of the large extrinsic value difference on that side of the market.
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.