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Last week we tracked an imaginary ITM long call at a strike price of 170 with a DTE of 19 AUG 22. In trader shorthand we might identify the contract as .AAPL220819C170. That’s the symbol we used at the end of the previous post to track how the option’s price moved. Here’s a reposting of that chart:
.AAPL220819C170 Y-axis starts at 6/1/22, ends at 8/19/22
The candles show daily movement and the purple line tracks the price of the underlying (AAPL)
At expiration the call was ITM (in the money) because the underlying stock’s price was greater than the strike price. When the price of the underlying exceeds the strike price of a call, we can say that the call has intrinsic value. If the strike price of a call is greater than the price of the underlying, the call has no intrinsic value. Our imaginary trade last week still had some intrinsic value (and only intrinsic value), which is what we would have realized when it was automatically exercised. Unfortunately, the price we paid for the contract exceeded its residual intrinsic value at expiration.
Prior to expiration the contract held extrinsic value as well as intrinsic value. Intrinsic value varies as the underlying price changes. Extrinsic value varies as multiple other factors change. Primary among those other factors is time until expiration. Extrinsic value decreases at an increasingly rapid rate as the expiration date approaches. You might recall last week, that if our imaginary trade were a real trade, I’d have closed the call on Wednesday or Thursday morning and taken a profit. Knowing how quickly extrinsic value erodes in the days just prior to expiration strongly informed the timing of my decision to close the trade.
A little more about intrinsic and extrinsic value. If the price of an underlying stock remains the same, its intrinsic value will also remain the same. Examine this capture of the option chain for Amazon (AMZN) and note that the intrinsic value of the options remains constant across all of the expiration dates listed:
Intrinsic and Extrinsic Values of Options
Unlike the intrinsic values, the extrinsic values are greater for options that are further into the future. You’ll hear people say that you can’t predict the stock market, but there’s a major exception to this rule: as sure as the amount of daylight decreases between the summer solstice and the winter solstice, so too will extrinsic value decrease. This is a simple truth that successful traders use to great advantage.