Extrinsic value measures the difference between the market price of an option, known as the premium, and its intrinsic value. Extrinsic value is also the portion of the worth that has been assigned to an option by factors other than the underlying asset’s price. The opposite of extrinsic value is intrinsic value, which is the inherent worth of an option.
Key Insights
- Extrinsic value is the difference between the market price of an option—its premium—and its intrinsic value (the difference between an option’s strike price and the underlying asset’s price).
- Extrinsic value rises with increases in market volatility.
Grasping the Fundamentals of Extrinsic Value
Extrinsic value, along with intrinsic value, comprises the cost or premium of an option. Intrinsic value is determined by the difference between the underlying security’s price and the option’s strike price when the option is “in the money.”
For example, if a call option has a strike price of $20 and the underlying stock is trading at $22, that option has $2 of intrinsic value. If the actual option trades at $2.50, the additional $0.50 is extrinsic value.
If a call option has value because the stock price is below the strike price, the option’s premium solely reflects extrinsic value. Conversely, if a put option has value due to the stock price being above the strike price, its premium comprises only the extrinsic value.
Factors Influencing Extrinsic Value
Extrinsic value is often called “time value” because one primary influencer is the time remaining until the option contract expires. Typically, a contract loses value as it approaches expiration because there’s less time for the underlying security to move in a favorable direction. For example, an out-of-the-money option with one month until expiration will have more extrinsic value than an out-of-the-money option with only a week until expiration.
Another critical factor affecting extrinsic value is implied volatility, which measures the anticipated price movement of an underlying asset over a specific period. If implied volatility increases, extrinsic value will rise. For instance, if an annualized implied volatility of 20% shoots up to 30% the following day, the extrinsic value will increase.
Image by Sabrina Jiang
Detailed Example of Extrinsic Value in Action
Let’s assume a trader buys a put option for XYZ stock, which is trading at $50. The trader purchases a put option with a strike price of $45 for $3, and it expires in five months.
At the time of purchase, the option has no intrinsic value since the stock price is above the strike price. Given consistent implied volatility and stock prices, as the expiration date nears, the option premium will trend toward zero.
If the stock price falls below the $45 strike price, the option gains intrinsic value. If the stock drops to $40, the option has $5 in intrinsic value. With time left before expiration, the option could trade for $5.50, $6, or more due to remaining extrinsic value.
Remember, intrinsic value does not equate to profit. For instance, if the stock drops to $40 as the option expires, it’s worth $5 from intrinsic value. Since the trader paid $3 for the option, the net profit would be $2 per share, not the entire $5.
Related Terms: Intrinsic Value, Option Premium, Strike Price, Implied Volatility, Expiration Date.
