Portfolios can be managed in many ways, have you ever thought of extrinsic value as one of them? Not as the only thing to manage it, but as one of the indicators?
Extrinsic value can be used with a variety of trades. I use it with diagonal calendars, credit trades, and covered calls, but first, let’s look at what it is.
Extrinsic value is the “extra” value in an option. It’s often called “time value.” Implied volatility is one of the biggest things affecting extrinsic value. If the extrinsic value of options for similar priced stocks is compared, you’ll see big differences if there’s a big difference in the implied volatility. Extrinsic value can help or hurt you, though, so watch it. Extrinsic value is the money you keep when you sell an option, if you hold it to expiration and extrinsic value is the money you pay if you hold a long option to expiration. In both cases more money may be exchanged if the underlying moves, but this is about extrinsic value so we’ll stick with that.
I do many diagonal calendars and cover calls on stocks with good implied volatility, which means they have good front month extrinsic value. The extrinsic value I sell provides a hedge, a profit, or both. When the trend doesn’t continue it’s a hedge, it’s a profit when I’m right, and both when I’m only partially right, which is most of the time. Other times extrinsic value is my comfort through a volatile period.
For the sake of brevity, I’ll stick to covered calls. There are three types of covered calls: ITM, ATM, and OTM. Each has its own risk-reward. The ITM covered call has lower risk, but lower reward when compared to the OTM covered call. In a stagnant trend you can pick your risk level and therefore your reward potential. So, what is your reward for an ITM covered call? The extrinsic value you sold. If the ITM covered call finishes ITM, your maximum profit is the extrinsic value you sold. If you choose an OTM covered call and it finishes OTM, what is you maximum profit? The extrinsic value you sold, unless you sell the stock too.
So how do you use extrinsic value to manage a trade? Well, it depends. In a stagnant trend I use it to determine when to roll. When extrinsic value gets to around .3 percent of the stock price, I roll to the next month, assuming I like the return, and the chart tells me it can work and there are no new events scheduled for that option’s life. Of course, I’m checking the possible rolls every day to see when would be best. Each day I’m weighing the extrinsic value I’m giving up by buying back my short call against the extrinsic value I’m picking up by selling the call in the next month out. Sometimes I’m even able to pick up some stock value by rolling to a little higher strike, but again that is another discussion.
The bigger challenge is when to roll a short call in a bullish trend. In general, it’s best to roll it before it goes ITM since delta will outpace theta. In some cases it’s best to buy back the short call and let the stock run, or buy a protective call. Of course, some stocks hit resistance when the short call is only slightly ITM. In that case the stock might rise up and put the short call ITM quickly, but then stall. In that case, letting the short call go ITM and waiting for extrinsic value to bleed off is the best thing to do.
How about a bearish trend? In that case, extrinsic value is your hedge or the cash you generate against your stock. Use the slope of the decline and your cost basis as your guide to know what to do with your short call. That discussion is a long one so I’ll leave that for another time.
One of the biggest challenges I seem to face when talking about ITM short calls are people’s fear of being called out early. Let me state, I have no fear of being called out early. I use extrinsic value to determine the likelihood of being assigned. I’ve been able to predict to 100 percent accuracy whether I’ll be assigned early on a short call or not, but I’ll leave that for my next blog.
Regardless of what you do with your short calls, make sure you’re sticking to your primary exit or your planned adjustments. Changing strategies mid-trade is a good way to give back profits or turn a profit into a loss.