What Makes Up an Option Contract’s Value/Premium?
- Intrinsic value is the portion of the option's value that is directly related to the underlying security's current market price.
- Extrinsic value on the other hand is the portion of the option's value that is determined by factors such as time to expiration and implied volatility.
- It reflects the potential for the option to gain additional value before expiration. The longer the time until expiration and the higher the implied volatility, the more extrinsic value an option will have.
- Extrinsic value decays over time as the option approaches its expiration date. This decline is what we call time decay, and it can significantly impact the option's value.
Time decay is straightforward, it’s what “Theta” is. If theta is .30, then you’re losing $30 in contract value for everyday you hold the contract.
Implied volatility measures the range of the move that markets expect from the stock and it’s a percentage. The higher the percentage, the bigger the expected move, but just because it’s a high percentage, doesn’t mean it will necessarily move that much.
So, how does this impact earnings plays?
Ahead of earnings, option contract implied volatility begins to rapidly increase. This is because the market expects a big move from the underlying stock. While on normal days, implied volatility is usually around 30-60% depending on the stock, ahead of an earnings day, the stock options for a specific stock can go up above 100 and 200%, drastically inflating their premium/value. So if the stock’s earnings reaction is flat, or not as big as expected (even if it moves in your direction), it will crush the implied volatility back to its normal levels or lower, taking the option premium down with it.