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
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