December 23, by Mike Butler. If you are buying an option, you are paying a premium for it - called a debit more on this later. If you are selling an option, you are receiving premium for the option - called a credit.
S ee how that works? Intrinsic value only exists when an option is in the money. As a refresher, remember that:. If the trade were to move in the money, there would be intrinsic value in the option part of what makes up the option premium. To calculate intrinsic value for the in the money option, you would subtract the strike price from the price that the stock is currently trading at. Summary of Intrinsic Value - intrinsic value does not exist for out of the money options.
For in the money options, intrinsic value is calculated by subtracting the strike price from the stock price stock price - strike price. Extrinsic value, also known as time value, is the difference between the current price of the option and the option's intrinsic value.
For out of the money options, the extrinsic value is equal to the market value of the option the premium paid. The factors that have an impact on this value are time decay theta decay and implied volatility. For in the money options, the extrinsic value is found by taking the total option premium and subtracting any intrinsic value from that number.
You can see the calculation of extrinsic value for an in the money option below. You should now be clear on what intrinsic and extrinsic value mean in relation to options premium. This concept seems easy on the surface, but may take some time to fully comprehend.
Take your time review these concepts and read through the post a few times if you are still confused. One thing that is important to remember about selling options for credit is that just because you receive the credit up front, does not mean you are guaranteed to keep that profit.
However, as time goes by, the value of that option will decrease. To close the position, you will be required to pay a debit unless you hold the option until expiration based on where the stock is trading relative to your strike price.
Whether or not you collect a credit for your trade is based on which type of trading strategy that you use, so let's take a look at some of the more common credit trading strategies.
As the option buyer, if I want to close the trade before the option expires, I can sell the option for a credit. The credit I receive will determine how much profit or loss the trade will result in. To help you place your next debit strategy, we have compiled a list of some of the more popular debit strategies. I hope that you will walk away from this post feeling much more comfortable with the terms premium, credit and debit.
If there are two things to take away from this post, I want you to remember that 1 option premium is the price of an option and is made up of intrinsic and extrinsic value. Watch Step Up to Options to learn more trading strategies. If you have questions about this post, be sure to tweet them to us at doughtrading or leave the question in the comments! In part 3 of our liquidity series we go over strike price volume.
The stock might be liquid, but is the strike price of the option you are trading? This week she is talking about IV Rank, see what questions the support desk gets the most! In part 2 of our liquidity series, we go over examining stock volume in dough. Beginner intermediate Blog Sign Up Login. Options Premium Credit and Debit Explained. Let's take a look at the term "premium" using a real-life example for more context.
Options Premium In Action! Intrinsic Value Intrinsic value only exists when an option is in the money. As a refresher, remember that: Intrinsic value for an in the money call option.
Extrinsic Value Extrinsic value, also known as time value, is the difference between the current price of the option and the option's intrinsic value.
A call option is out of the money when the stock price is less than the strike price A put option is out of the money when the stock price is greater than the strike price For out of the money options, the extrinsic value is equal to the market value of the option the premium paid. Extrinsic value is calculated for an in the money call option.
Debit Strategies List Here is a list of popular debit strategies: Get started selling premium by signing up for dough today! Strike Price Volume Liquidity Part 3. Jul 2, beginner iv rank , implied volatility , high implied volatility , education , Tracy Algeo Tracy Algeo Comment. Stock Volume Liquidity Part 2.More...