At first, options can be a very complex entity to understand. But if a trader looks at things from a fundamental perspective, it may become clearer. The options world is ruled by three basic forces consisting of: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the architecture of the options trade under consideration.
For the new options trader, learning about options and the impact of these three fundamental forces may be confusing and the magnitude of the influence of each on the profitability of trades is easily under-appreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders start out as being stock traders where “only price pays” the initial reluctance and hesitation to consider additional factors impacting a trade is easily understood.
In order to help understand the initially confusing manner in which options respond to their outside and inside forces, it is helpful to breakdown an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium and is impacted by both time to expiration and IV.
Senior Options Instructor