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Home // Uncategorized // Intrinsic Value of an Option: Earn a Living Trading Options – Video 3 Part 2

Intrinsic Value of an Option: Earn a Living Trading Options – Video 3 Part 2

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As we get closer to the third Friday of May,the chances of that stock moving above the strike price of \$27.50 becomes less and less certain, and because of that the option has less value to it.

If you take a look at an optionlike this overtime, let’s say that the stock doesn’t really move.  Maybe in a week from now,this option will be selling for 20 cents bidand 35 cents ask; a week after that it’s 15 cents and 20 cents or 25 cents.  The week after that maybe it’s 5 cents and 10 cents.  So eventually the option that you purchased at 40 cents with great hope that the stock was going to move upis now only worth about 10 cents.  You’ve lost 30 cents on the trade.

Well that’s exactly what the person who sold it to you is hoping would happen.  That in fact, the stock did not go up in price.  That you purchased this option that they know is going to expire and will eventually erode in value over time.  That’s how they make their profit because they sold it to you at 40 cents; they can buy it back at 10 cents; and make 30 cents on that trade.

What about the guy who purchased the put option?  Theoption that gives him the right to sell the stock at \$27.50 and hoping that it would go down so he could buy it back at \$22.50.  If he could buy it at \$22.50 and sell it at \$27.50, he’s made a \$5 profit.  And that’s what his hope is.

Now if the stock doesn’t do anything at all, the same exact thing is going to happen to his put option.  Eventually over time, because the actual probability that the stock is going to decline in price decreases as these options get closer to expiration.  Then this option will be worth less and less each week.  Let’s say next week at this time if the stock does not move then this option will only be worth maybe 45 cents to 65 cents.  Another week passes by and it’s only worth 35 cents to 45 cents.  Now another week passes by and it’s only 25 cents.  As long as the stock does not move, all of these options will continue to decline in price if they have extrinsic value.

Now the prices of theseoptions are called “in the money” options.  In the money options have some component of what they call extrinsic value and some component of intrinsic value.  The way that you can determine intrinsic and extrinsic value is simply by taking the strike price of the option, in this case we’re taking a look at the May 20 calls, and their price is \$7.40.  On these 20 calls, if you add the strike price to the price of the call, you get \$27.40.  At the mid-price you’re probably talking closer to \$27.25, which is exactly the price of our current stock.  So you can say that this call option has no intrinsic value. In fact, if we look under the extrinsic value, you can see that it is actually zero.

The closer you get to “in the money” or the actual strike price of the stock, you can see that there is, in fact, some extrinsic value left.  There is some time value left in that option and that time value is basically saying that “hey you know what, we do have three or four weeks before expiration” so the price of the option may actually increase to the point where it might be actually further in the money.

What is our objective, though?

This is just a very brief.  You should already have a basic understanding of options.  I probably haven’t told you anything new.  Or maybe I have, I don’t know; but that depends on your experience.  The important thing to remember, though,is that when we trade for monthly income the stock cannot be in two places at one time.  At expiration we’re going to make money on one side or the other.  That’s an important distinction tomake because we make money whether the stock goes up or goes down.

Now the types of vehicles that we use in order to trade options on the exchanges are normally going to be,and I’ll go through all those with you in the next series herein portfolio building.  What we’re going to be using are(proprietary information edited out) adjustments.  Adjustments are everything because as I said, prices fluctuate.  That is oneinviolate rule of the market:  prices will fluctuate.  We don’t care if they go up or down but they do fluctuate.

There are a couple of rules to the option markets and that’s the two I’ve already told you.  The third one is don’t lose money.  So, the rules are:  prices fluctuate,options expire at a date in the future, and don’t lose money.

In order not to lose money, many times we have to do adjustments to our original positions.  This is where a lot of option players make a mistake.  They do not adjust their positions.  They put a position on and they believe that they can just keep it on there until expiration.  Well, they forgot about the other rule of the market and that is prices will fluctuate.  Options expire but they also fluctuate so if you get into a position, and a lot of option players do this, they just put positions on and they forget about them.  They don’t even look at them until they have a loss and then it’s too late to do anytype of adjustment to that position because they are already too far gone.

Our goal is to monitor your positions.  You put these positions on and then we will show you exactly what you need to do in order to adjust the positions.  That’s where the majority of the real profits come in this business.  What happens to a business when it’s not making money all of a sudden?

Well, just like this, if we’re not making money, then we have to take a look at the source of the problem and adjust our strategy in order to take advantage of new market conditions.  That’s exactly what any business has to do.  Any businessthatis not in a profitable position has to take a look at their business model and that’s exactly what we do in our business of trading.  That’s why it really is a business because we manage by numbers and that’s what all good big businesses do.  They manage by numbers.

This is an aggregate position ofour demonstration account for the purpose of these videos.  You will see this throughout all the videos that we’re creatingon this strategy.  We start out in a cash position,but I also want to show you what the profit potential of having more contracts is.  Eventually as you get experience in this type of trading as a business, you’re going to be able to have a great deal of confidence in your ability to adjust trades over time.

I suggest that you begin with paper trading.  Now the thinkorswim platform has a papertrading account that you can set up for free.  It looks identical to this.  The only thing that is differentis if you look up in this top left hand corner, this is a live trading account.  It has a red symbol here with the thinkorswim symbol and logo.

If you have a paper trading accountopen, this is a green symbol but the platform is absolutely identical.  Everything is exactly the same.  You can enter trades, you can adjust trades, you can look at charts, and you can monitor your account.  You can do everything that you can in the paper trading account with thinkorswim, as you can in this account.

If you’re looking for a simple trading system, check out the Genius Trading System