Candlestick Trading Blog

---

Wouldn’t be great if you could trade in the stock market and own a crystal ball, the kind that tells the future? With option value you may not have a crystal ball, but you do have some insight on how strong an asset on which you have purchased an option really is. By identifying the break even point of an option you are able to see where your profit or loss is in relation to that point.

Intrinsic and Extrinsic Values Defined
An option’s value can be broken down into two parts: extrinsic value and intrinsic value. Intrinsic value is the portion of the option that can be gained if the option is exercised. Extrinsic value is anything above the intrinsic value; this is also known as the time value.

An Example of Intrinsic and Extrinsic Values

Consider the following example:

Underlying: MEW Industries
Underlying Price: $18
Type: Call Option (American style stock order)
Strike Price: $15
Expiry Date: 8th September

Now, imagine that this particular call option is currently trading at $5. Let’s dissect this price.

First we can look at the intrinsic value; this is the option’s value that, if traded, would create a profit. We know that the call option's strike price is $15 and with MEW Industries trading at $18 it is already worth at least $3. This is an example of intrinsic value; this is the profit that can be made by exercising the option.

What They Really Mean
We know that the option is worth $3, which is its intrinsic value, but it is really trading for $5. The other $2 is called the extrinsic value; it indicates the option value that the market puts on this asset.

An option value that is sitting at 0 intrinsic value is said to be “out of the money”; this means that if you exercised your position at this time you would lose money. If you were to buy this call option on MEW Industries at $20 and market value is $19, you lose money; not exactly the picture of successful trading. At the same time, don’t think that there isn’t any option value to an asset with 0 intrinsic value; it can still have option value because traders believe that there is still some chance that the underlying could trade in a favorable direction, which would make the option profitable.

No Value is Still Valuable?
Option value is relative. Consider this; a position has an option value of zero, in other words it has no intrinsic value. Yet this same option has a price of $1.75; should you assume the option value is overpriced? Not necessarily. If you look at the option, it still has six months before it expires which gives it plenty of time to gain investing value. If it expired tomorrow, it would be considered worthless, but now there are still 120 or more days in which it can rise; this indicates the option’s value related to time.

Conclusion
Option value is important both the current value of a position but its future as well. When considering whether to keep a position or trade out of it early, it is wise to calculate the option value to help determine whether it is likely to improve its position or fall back.

Calculating option value can be a technical analysis tool that you utilize along with candlestick charting to verify your positions. Stock charting with a system like Japanese Candlesticks is an excellent method of verifying your analysis and anticipating the direction of a position. Using this method along with calculating option value can help you to become more successful with options trading.