Episode Transcript
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Speaker 1 (00:03):
Welcome to the
Options Trading Podcast.
We're on a mission to empowerindividual investors with the
knowledge they need.
Join us as we break downcomplex topics into simple,
step-by-step guidance forconservative options trading.
Speaker 2 (00:16):
Options trading.
It's this area that pulls a lotof people in, you know, with
this idea of making big moneyfast.
But if you've ever actuallytried it, or maybe just watched,
you probably know that for mostpeople it feels less like a
smart strategy and more likebuying a lottery ticket, and
often the money just kind ofvanishes.
Speaker 3 (00:36):
It's a really common
pattern and, honestly, a lot of
it just boils down to notgetting the basic pieces of an
options price.
People see that price tag butthey don't really grasp what's
bundled up inside.
Speaker 2 (00:50):
Right, it's like
buying some complex gadget just
based on the sticker pricewithout knowing what the
individual parts actually cost.
So, ok, our mission in thisdeep dive we've got this stack
of sources you brought is toreally break down those two
fundamental parts intrinsicvalue versus extrinsic value.
We want to help you, thelistener, look at an option
price and actually know whatyou're paying for.
You know, move from justguessing to really understanding
(01:14):
.
Speaker 3 (01:14):
And before we really
unpack those two values, maybe
let's just quickly touch on theabsolute basics from the
material.
So, an option, it's a contract.
It gives the buyer the right.
An option it's a contract, okay, it gives the buyer the right,
but and this is key, not theobligation, to either buy that's
a call option or sell that's aput option.
Some asset?
Like a stock Right At aspecific price that's the strike
(01:35):
price, and it has to be done onor before a certain date, the
expiration date.
Speaker 2 (01:40):
Okay, right, not the
obligation Trade at a set price
by a deadline.
Seems simple enough, but thesources really hammer home this
key formula for the price youpay for that right.
Speaker 3 (01:50):
Absolutely, it's
foundational.
The equation is always option.
Price equals intrinsic valueplus extrinsic value.
Every single penny of thatprice falls into one of those
two buckets.
Speaker 2 (02:00):
And the sources had a
pretty good analogy for this,
didn't they Something about asandwich?
Speaker 3 (02:04):
Yeah, it helps
visualize it.
Think of intrinsic value as themeat in the sandwich.
It's the solid bit, the partthat has real substance right
now.
Okay, the meat, extrinsic value, that's well everything else
the bun, the lettuce, mayo,whatever all the other stuff
that adds to it or addspotential, but isn't the core
value itself.
Speaker 2 (02:24):
So it sounds like a
lot of people might be paying
quite a bit for the bun, kind ofhoping there's some meat inside
.
Let's start with the meat, thenIntrinsic value.
Speaker 3 (02:32):
Right, so intrinsic
value is the part of an options
price that is already in themoney.
In the money, meaning?
Meaning like if you could snapyour fingers and exercise that
option right now, this verysecond, would it actually be
worth something?
Would you make money, justbased on the current market
price?
Speaker 2 (02:48):
Okay, Walk us through
the example.
They used the Apple one.
Speaker 3 (02:51):
Sure.
So imagine Apple stock istrading right now at $180 per
share and you own a call optionthat gives you the right to buy
Apple at $170.
Speaker 2 (03:01):
Okay, so my contract
says I can buy $170, but the
market says it's worth $180right now.
Speaker 3 (03:06):
Exactly so that $10
difference per share, the $180
market price minus your $170strike price, that is the
intrinsic value.
It's real, it's immediate, it'sthe meat you get if you
exercise right away.
Speaker 2 (03:17):
Got it.
Yeah, that's like actual valueI'd have if I acted now.
Okay, but what if Apple wasdown, say, trading at $160, and
I still had that same $170 calloption?
Speaker 3 (03:29):
Ah, good question.
In that situation, your rightto buy at $170 is well, it's
higher than the current marketprice of $160.
Speaker 2 (03:38):
So exercising would
mean paying more than it's worth
.
Speaker 3 (03:45):
Precisely.
You'd be buying at $170something you could immediately
sell for only $160.
That's a loss, so the option isout of the money, right, and in
that case its intrinsic valueis zero Zilch.
There's no immediate profitbaked in from exercising.
Like the source material saysno meat, just soggy bread.
Speaker 2 (03:59):
Okay, so you can't
have negative intrinsic value.
Then it's either positive or itbottoms out at zero.
Speaker 3 (04:04):
Exactly right.
That's a super important point.
The math works like this Forcalls intrinsic value is stock
price minus strike price, butonly if that's positive.
If the stock price is below thestrike or equal, intrinsic
value is zero.
And for puts the right to sellit's flipped Strike price minus
stock price, Again, only ifthat's positive, Otherwise it's
zero All right.
Speaker 2 (04:23):
Intrinsic value is a
real, verifiable, right now
profit potential.
Got it?
Let's tackle the other side.
Extrinsic value.
This feels, I don't know, maybethe fuzzier part, the trickier
one.
Speaker 3 (04:38):
It definitely can be.
Extrinsic value is basicallyeverything else in that options
price.
That isn't intrinsic value.
It's the component that's basedon the what if?
Speaker 2 (04:49):
The what if like.
What if the stock moves?
Speaker 3 (04:50):
Exactly.
It represents the market'sexpectation, or maybe just hope,
that the stock price will movefavorably before that option
expires, and our sources sayit's driven primarily by two big
things how much time is leftuntil expiration?
Speaker 2 (05:03):
OK.
Speaker 3 (05:04):
And the expected
volatility of the stock, how
much people think it's likely tojump around?
Speaker 2 (05:08):
Time and potential
movement OK.
Speaker 3 (05:09):
So the more time you
have left generally, the greater
the chance for some big priceswing Right.
So options with like months togo usually have more extrinsic
value built in than optionsexpiring next week.
You're paying for more days ofpossibility.
Speaker 2 (05:23):
But that possibility,
that hope factor, yeah.
It doesn't last forever, doesit?
Yeah.
This is where that time decaything comes in.
Speaker 3 (05:30):
Bingo.
Yeah, this is the silent killerfor a lot of option buyers.
Every single day that ticks by,a little bit of that extrinsic
value just evaporates, decays.
Why?
Because there's simply lesstime remaining for that hoped
for big move to actually happen.
The possibility you paid for isshrinking day by day.
Speaker 2 (05:48):
OK, let's, let's go
back to that Apple example to
make this concrete.
Speaker 3 (05:51):
OK, so Apple's still
trading at one hundred and
eighty dollars.
You've got that one hundred andseventy dollar strike call
option and let's say there are30 days left until it expires.
The sources suggest maybe thetotal price for that option is,
say, $12.
Speaker 2 (06:04):
Okay, and we already
figured out that $10 of that,
$12 is the intrinsic value, thereal stuff.
Speaker 3 (06:08):
Right, so the
remaining $2, that difference,
that is the extrinsic value,that $2 represents the time
value, the market premium forthose 30 days of potential that
Apple might go even higher.
Speaker 2 (06:19):
And if the next day
Apple is still $180, hasn't
moved, but now there are only 29days left.
Speaker 3 (06:24):
Well, that options
price will likely have dropped a
little bit, maybe to $11.
Speaker 2 (06:30):
Even though the stock
didn't change.
Speaker 3 (06:32):
Even though the stock
didn't change that 20 cents
didn't disappear because ofApple's price.
It vanished purely because oftime decay, eating away at that
initial $2 of extrinsic value.
If you're the buyer, the clockis ticking against you Wow.
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Speaker 2 (07:18):
Okay.
So if absolutely nothingchanges with Apple's stock price
day after day by the timeexpiration day actually arrives,
that option will only be worthits intrinsic value, which is
still $10 in this case, exactlythat whole $2 of extrinsic value
you paid up front will havecompletely melted away to zero.
Speaker 3 (07:37):
Precisely, and this
is really where extrinsic value
can kind of trick people,especially new traders.
They end up paying mostly forthat hope, that potential future
move, not realizing how quicklyit disappears.
Speaker 2 (07:48):
And I bet this is
even more stark with options
that start out of the moneyright, the ones with zero
intrinsic value to begin with.
Speaker 3 (07:53):
Oh, absolutely.
The sources use a great examplefor this.
Imagine a stock is trading at$50 and you decide okay, I think
it's going up, so you buy acall option with a $60 strike
price and maybe you pay $1 forthat option.
Speaker 2 (08:05):
Okay, a $60 strike
when the stock's only at $50,
that means zero intrinsic value,right?
No meat at all, correct?
Speaker 3 (08:11):
Zero.
So every single penny of that$1 premium you paid it is pure,
100%, extrinsic value.
You are literally paying adollar just for the chance, the
possibility that the stock pricedoesn't just get to $60, but
actually goes above $61 beforeexpiration, just for you to
break even on the trade.
Speaker 2 (08:31):
And if that big jump
doesn't happen, that dollar is
just gone, melting away everyday because of decay.
The sources really stress howthis might seem like a small
loss on one trade, but it addsup fast, yeah.
Or it can be a big loss if theoption was more expensive.
It's how money gets lost,slowly and quietly.
Speaker 3 (08:48):
Yeah, it's the cost
of admission for a potential
future that might just nevershow up.
Speaker 2 (08:52):
OK, now this next bit
from the sources.
This is where the perspectivereally shifts.
It's fascinating.
They start talking about beingthe seller of the option.
Speaker 3 (09:00):
Right, and this is
where understanding intrinsic
versus extrinsic is justincredibly powerful, because,
while most people are drawn tobuying options, hoping for that
home run the person on the otherside of that trade, the seller
they're playing a completelydifferent game.
Speaker 2 (09:18):
How so.
Speaker 3 (09:19):
Well, they are the
ones who collect that extrinsic
value premium upfront.
Speaker 2 (09:23):
Wait, they're selling
the hope the buyer is paying
for.
Speaker 3 (09:26):
That's a perfect way
to put it.
The material describes itreally vividly.
When you sell an option, you'reessentially selling hope,
you're selling time, you'reselling emotion, maybe fear or
greed, and what do you getimmediately in return?
Speaker 2 (09:39):
The premium.
Speaker 3 (09:40):
Cold hard cash
instantly credited to your
account.
Speaker 2 (09:43):
OK, so if the stock
doesn't make that big move the
buyer was hoping for, thatextrinsic value just evaporates
over time, like we said.
Speaker 3 (09:51):
And where does it
evaporate to?
It disappears from the optionsprice, but it effectively stays
in the seller's pocket.
That premium they collectedbecomes their profit.
Yeah, one source uses theanalogy of selling ice cubes in
the desert.
As a seller, you kind of knowthat time decay is going to meld
away that hope value.
Time is actively working foryou because that extrinsic
premium you pocketed is destinedto shrink towards zero if the
(10:14):
option doesn't go deep in themoney.
Speaker 2 (10:16):
That really does flip
the whole thing on its head.
You go from fighting againsttime decay to actually
benefiting from it.
Speaker 3 (10:22):
And getting that
fundamental difference
immediately shines a light onthe common traps that so many
new options traders fall into.
The sources are really clearabout these pitfalls.
Speaker 2 (10:32):
Okay, what are the
big ones, the main mistakes
people make.
Speaker 3 (10:35):
Well, number one is
just ignoring this whole
distinction.
We've been talking aboutIgnoring intrinsic versus
extrinsic.
They just see a price, buy itand don't realize they might be
paying a massive premium justfor hope, you know, with very
little actual tangible valueunderneath.
Speaker 2 (10:50):
This probably leads
right into the next one.
Yeah, Chasing those super cheapway out of the money options.
Speaker 3 (10:55):
Absolutely.
The sources call them what theyare lottery tickets.
They look cheap, maybe only afew cents, but because they have
zero intrinsic value, theirentire price is extrinsic value.
Speaker 2 (11:07):
Which decays really
fast.
Speaker 3 (11:09):
Super fast and
they're basically designed
statistically to expireworthless unless you get a huge
unlikely move in the stock pricevery quickly.
You need a massive win just tobreak even sometimes.
Speaker 2 (11:21):
Okay, Another mistake
they mentioned holding on too
long, holding right untilexpiration.
Speaker 3 (11:26):
Yeah, this ties
directly back to how time decay
works.
It's not a straight line down.
It actually accelerates thecloser you get to the expiration
date.
Speaker 2 (11:33):
Oh right, Like the
decay speeds up near the end.
Speaker 3 (11:36):
Exactly.
The loss of extrinsic value perday gets faster and faster in
those final weeks or days.
So holding on as a buyer untilthe very end means you're
exposing yourself to the mostrapid decay.
Speaker 2 (11:47):
Like the analogy they
used waiting to pull the
parachute cord until you're only100 feet from the ground.
Speaker 3 (11:51):
Pretty much Not a
good strategy for the buyer.
For the seller, though, thataccelerating decay is expiration
years.
That's exactly what they wantto see.
Speaker 2 (11:59):
And the last big
mistake was just not getting
that the decay is exponentialnot just a steady trickle.
Speaker 3 (12:09):
Yeah, understanding
that acceleration is key.
That extrinsic value doesn'tjust politely decline.
It falls off a cliff towardsthe end.
Buyers need to grasp thatbecause it tells them when that
hope value they paid for isgoing to vanish most rapidly.
Speaker 2 (12:20):
Okay.
So, knowing all this,understanding these two parts of
the price and how decay works,what are the practical,
actionable tips the sources giveus?
Speaker 3 (12:30):
All right.
So, based on this coreunderstanding, the advice is
pretty clear.
If you are buying options,especially calls, the sources
generally recommend focusing onoptions that are already in the
money.
Why?
Because a larger portion of theprice you pay will be for that
solid intrinsic value, the meatYou're spending less on the
purely speculative extrinsicvalue that's going to decay away
(12:51):
.
Speaker 2 (12:51):
Pay for the meat, not
just the bun and the hope sauce
.
Exactly.
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Speaker 3 (13:25):
Now, conversely, if
you are selling options, the
strategy flips.
You'd often target thoseout-of-the-money options,
particularly ones that stillhave a decent amount of
extrinsic value packed intotheir price.
Speaker 2 (13:35):
Because that's the
part you collect and hope decays
.
Speaker 3 (13:38):
That's where the
juice is, as one source puts it.
That's the premium you pocket,and if the stop doesn't make a
huge move against you, timedecay works in your favor to
erode that value.
Speaker 2 (13:50):
And obviously keeping
a close eye on the calendar is
crucial either way.
Speaker 3 (13:53):
Oh, absolutely vital.
Time is probably the biggestfactor besides the stock price
itself.
It's constantly working againstthe buyer, constantly helping
the seller.
Assuming the price stays stable, you absolutely have to manage
your trades based on how muchtime is left.
Speaker 2 (14:08):
And the sources
brought up a specific term for
measuring this decay theta.
Speaker 3 (14:13):
Yeah, theta.
It's one of the Greeks, whichare just metrics used to measure
different risks andcharacteristics of options.
Theta specifically tells youhow much extrinsic value an
option is expected to lose perday just due to the passage of
time.
Speaker 2 (14:27):
So buyers don't want
high theta.
Speaker 3 (14:29):
Generally no.
High theta means the option'stime value is decaying quickly.
Sellers, on the other hand,often look for high theta
situations because they profitfrom that rapid decay quickly.
Sellers, on the other hand,often look for high theta
situations because they profitfrom that rapid decay.
Speaker 2 (14:39):
Huh, so understanding
intrinsic versus extrinsic and
how time decay like theta works,yeah, it's not just theory, it
directly shapes your strategy.
Speaker 3 (14:51):
It fundamentally
changes the game and moves you
away from treating options likeyou know random bets on a
roulette wheel and towardsunderstanding the actual
mechanics.
The sources really nailed thispoint.
Options aren't magic.
They're based on math andquantifiable factors, and when
you truly grasp intrinsic andextrinsic value, you stop being
the person just kind of hopingfor that long shot payout.
(15:14):
And you can start thinking morelike the house, as they put it,
the one who aims to make moneymore consistently like a casino,
small wins often predictably,primarily from capturing that
decaying extrinsic value thatothers are willing to pay for.
Speaker 2 (15:26):
And our sources leave
us, and you listening, with a
really sharp set of questions toask next time you even glance
at an option price.
Speaker 3 (15:33):
Yeah, they urge you
to stop and ask yourself first
OK, how much of this price isreal, tangible value right now?
How much is intrinsic?
And how much of this price isjust hope?
How much is just paying fortime and possibility?
How much is extrinsic?
Speaker 2 (15:45):
And then the big
strategic question follows from
that.
Speaker 3 (15:47):
And knowing that, do
I want to be the buyer of that
hope or do I want to be theseller of that hope?
Grasping that difference, theyargue, is the absolute key to
making informed decisionsinstead of just gambling.
Speaker 2 (16:00):
And you know, if you
take that core idea that part of
the price of something can bepurely based on time and the
possibility of future events,that hope value versus the real
value, how does that change howyou might look at any potential
investment, not just options?
Where else in your financiallife, or maybe even other areas,
are you potentially paying forhope instead of focusing on the
(16:21):
underlying verifiable value?
It's a pretty interesting lensto carry around.
This is an AI podcast based oneducational material from Option
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