Intrinsic Value vs. Extrinsic Value in Options Trading
Options are priced based on two components: intrinsic value and extrinsic value. Understanding the difference between these two components is essential for options traders to quickly determine how much an option is worth.
What is Intrinsic Value?
Intrinsic value is the difference between the option strike price and the current market price of the underlying asset when the option is in the money. In other words, intrinsic value is the amount of profit that can be realized if the option is exercised immediately.
For example, if a call option has a strike price of $50 and the underlying stock is trading at $55, that option has an intrinsic value of $5. Similarly, if a put option has a strike price of $50 and the underlying stock is trading at $45, that option has an intrinsic value of $5.
Intrinsic value can be positive or zero. Positive intrinsic value means that the option is in the money, and zero intrinsic value means that the option is out of the money.
What is Extrinsic Value?
Extrinsic value is any value that is not intrinsic, so therefore out of the money options only have extrinsic value. Extrinsic value is also known as time value because it represents the amount that option buyers are willing to pay for the possibility that the option may become profitable in the future. Extrinsic value depends on various factors, such as time to expiration, implied volatility, interest rates, and dividends.
Extrinsic value decreases as the option approaches its expiration date because there is less time for the underlying asset to move favorably for the option holder. This phenomenon is known as time decay or theta decay.
Extrinsic value also decreases when implied volatility decreases because there is less uncertainty about the future price movements of the underlying asset. Conversely, extrinsic value increases when implied volatility increases because there is more uncertainty about the future price movements of the underlying asset.
Calculating Intrinsic Value for Call Options
Call options have intrinsic value when the underlying asset's market price exceeds the strike price. The formula for calculating intrinsic value for call options is:
Call Option Intrinsic Value = Market Price - Strike Price
For example, if a call option has a strike price of $50 and the underlying stock is trading at $55, that option has an intrinsic value of $5. If the stock is trading at $50 or below, that option has zero intrinsic value.
Calculating extrinsic value for call options
Extrinsic value for call options is calculated by subtracting intrinsic value from the premium of the option. The formula for calculating extrinsic value for call options is:
Call Option Extrinsic Value = Premium - Intrinsic Value
For example, if a call option has a strike price of $50 and a premium of $6, and the underlying stock is trading at $55, that option has an intrinsic value of $5 and an extrinsic value of $1 ($6 - $5).
Calculating Intrinsic Value for Put Options
Put options have intrinsic value when the underlying asset's market price is lower than the option's strike price. The formula for calculating intrinsic value for put options is:
Put Option Intrinsic Value = Strike Price - Market Price
For example, if a put option has a strike price of $50 and the underlying stock is trading at $45, that option has an intrinsic value of $5. If the stock is trading at $50 or above, that option has zero intrinsic value.
Calculating extrinsic value for put options
Extrinsic value for put options is calculated by subtracting intrinsic value from the premium of the option. The formula for calculating extrinsic value for put options is:
Put Option Extrinsic Value = Premium - Intrinsic Value
For example, if a put option has a strike price of $50 and a premium of $6, and the underlying stock is trading at $45, that option has an intrinsic value of $5 and an extrinsic value of $1 ($6 - $5).
What Affects the Amount of Extrinsic Value?
As mentioned earlier, extrinsic value depends on various factors, such as time to expiration, implied volatility, interest rates, and dividends. Here is a brief explanation of how implied volatility and time value affect extrinsic value.
Implied volatility
Implied volatility affects extrinsic value because it indicates the probability of the option becoming in the money or more in the money before expiration. The higher the implied volatility, the higher the extrinsic value, and vice versa.
Time value
Time value is the portion of extrinsic value that reflects the amount of time left until expiration. Time value affects extrinsic value because it indicates how much time the underlying asset can move favorably for the option holder. The longer the time to expiration, the higher the extrinsic value, and vice versa.
Intrinsic Value vs. Extrinsic Value - Bottom Line
Intrinsic value and extrinsic value are two components that determine the price or premium of an option. Intrinsic value is the difference between the option strike price and the underlying asset's market price when the option is in the money.
Extrinsic value is any value that is not intrinsic, and it depends on various factors, such as time to expiration, implied volatility, interest rates, and dividends. Options traders need to understand how these two components affect their risk and reward, as well as their trading strategies.
