What is Extrinsic Value in Options Trading?

In the options world, intrinsic and extrinsic value together represent the total value (aka premium) of an option. 

The intrinsic value of an in-the-money (ITM) option at expiration is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero.

Extrinsic is the term used for the value of an option beyond its intrinsic value. Stated differently, extrinsic value is the part of the option premium that is not intrinsic value. 

Extrinsic value is sometimes referred to as “time value” because it reflects the possibility that an option may become ITM before expiration.

An options extrinsic value is generally influenced by the following factors: 

• Time to Expiration: The more time an option has until it expires, the greater the chance that it could become ITM. Therefore, options with a longer time until expiration have more extrinsic value than options that are closer to expiration.

• Implied Volatility: If the underlying asset's price is volatile, there's a greater chance that the option could become ITM. Therefore, options on more volatile assets usually have more extrinsic value.

• Interest Rates and Dividends: Changes in interest rates and expected dividends can also influence an option's extrinsic value. Higher interest rates generally increase the extrinsic value of call options and decrease the extrinsic value of put options. Expected dividends generally decrease the extrinsic value of call options and increase the extrinsic value of put options.

When an option gets closer to being in-the-money (ITM), it can affect both the intrinsic and extrinsic value of the option.

The intrinsic value of an option increases as the option moves further into the money. If the option is out-of-the-money (OTM) and the stock price moves to a point where the option becomes ITM, the intrinsic value increases from zero to the amount by which the stock price exceeds the strike price (for a call) or is lower than the strike price (for a put).

Extrinsic value, also known as time value, is also affected, but the relationship is a bit more complex. 

Extrinsic value is generally higher when the option is at-the-money (ATM). This is because there is greater uncertainty or greater perceived risk/reward when the strike price and the underlying price are the same. As the option moves further into the money or further out of the money, the extrinsic value tends to decrease, because of the simultaneous decline in uncertainty of where the option will be at expiration. This pattern is known as the "volatility smile" due to the shape of the curve when graphed.

It's important to note that the effect of the stock price moving closer to the strike price is just one factor that affects the extrinsic value. Other factors, such as time until expiration, the implied volatility of the underlying asset, interest rates, and dividends, can also affect the extrinsic value of an option.

The impact of these factors on extrinsic value is detailed below: 

• Time to Expiration: The more time an option has until expiration, the greater its extrinsic value. This is because there is more time for the underlying asset to move in a favorable direction. As the option approaches its expiration, its extrinsic value will decrease, a phenomenon known as time decay.

• Implied Volatility: The price volatility of the underlying asset also affects the extrinsic value of an option. Higher implied volatility means more extrinsic value because it raises the possibility that the option could move into-the-money. Conversely, lower volatility reduces the extrinsic value.

• Interest Rates: Changes in interest rates can affect the extrinsic value of an option. When interest rates rise, the extrinsic value of call options generally increases, while the extrinsic value of put options typically decreases. This is because higher interest rates increase the cost of carrying a position in the underlying asset.

• Dividends: If the underlying asset is a stock that pays dividends, the expected dividends can influence the extrinsic value of options. Expected dividends generally reduce the extrinsic value of call options and increase the extrinsic value of put options. This is because dividends reduce the price of the stock, which impacts the likelihood of the options ending up in-the-money.

The extrinsic value of an option can be calculated by subtracting the option's intrinsic value from the total value of the option if it exists, as detailed below: 

• Calculate Intrinsic Value: Intrinsic value is the amount by which the option is in-the-money. For call options, this is the amount by which the price of the underlying asset exceeds the option's strike price. For put options, it's the amount by which the strike price exceeds the price of the underlying asset. If the option is out-of-the-money, the intrinsic value is zero.
  
  
  Subtract Intrinsic Value from Market Price: The market price (or premium) of an option is made up of its intrinsic value plus its extrinsic value. Therefore, once you have calculated the intrinsic value, you can determine the extrinsic value by subtracting the intrinsic value from the market price of the ITM option. If the option is OTM, it is made up of pure extrinsic value.

Looking at an example, imagine you have a call option with a strike price of $50, and the underlying stock is currently priced at $55. The market value of the option is $7.

First, calculate the intrinsic value: $55 (underlying price of the stock) - $50 (strike price) = $5.00.

Next, calculate the extrinsic value: $7 (option market price) - $5 (intrinsic value) = $2.00.

Therefore, in this example, the extrinsic value of the option is $2.00.

It's important to note that while this calculation gives you the extrinsic value based on the current market conditions, the actual extrinsic value at any future point in time will be influenced by factors such as time decay, changes in volatility, and changes in interest rates and dividends. This $2.00 figure in this example can increase and decrease as the market environment changes.

In the options world, intrinsic and extrinsic value together represent the total value of an option. 

The intrinsic value of an in-the-money (ITM) option at expiration is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero.

Extrinsic is the term used for the value of an option beyond its intrinsic value. Stated differently, extrinsic value is the part of the option premium that is not intrinsic value. 

Extrinsic value is sometimes referred to as “time value” because it reflects the possibility that an option may become ITM before expiration.

Learn more about intrinsic value.

Detailed below are separate examples of extrinsic value for a call and for a put. 

Extrinsic Value of a Call Option

Imagine you have a call option with a strike price of $50, and the underlying stock is currently priced at $55. The market value of the option is $7.00

First, calculate the intrinsic value: $55 (underlying price of the stock) - $50 (strike price) = $5.00.

Next, calculate the extrinsic value: $7 (option market price) - $5 (intrinsic value) = $2.00.

Therefore, in this example, the extrinsic value of the option is $2.00.

Extrinsic Value of a Put Option

Imagine you have a put option with a strike price of $20, and the underlying stock is currently priced at $16. The market value of the option is $5.00.

Intrinsic value = $20 (strike price) - $16 (underlying price of the stock) = $4.00.

Next, calculate the extrinsic value by subtracting the intrinsic value from the market price of the option:

Extrinsic value = $5 (option market price) - $4 (intrinsic value) = $1.00.

Therefore, in this example, the extrinsic value of the put option is $1.00.

Options that are at-the-money (ATM), meaning the strike price is equal to the current price of the underlying asset, typically have the most extrinsic value. This is because there is the greatest uncertainty about whether these options will end up in-the-money at expiration, which increases the time value.

Additionally, options with longer time until expiration will have more extrinsic value than similar options with shorter time until expiration. This is because the longer the time until expiration, the greater the chance the option has to become in-the-money, which increases the time value.

Extrinsic value is also affected by implied volatility. The higher the implied volatility of the underlying asset, the more extrinsic value the option will have. This is because a higher volatility implies a greater chance of large price movements, and thus a higher probability that the option will become in-the-money.

Yes, out-of-the-money (OTM) options do have extrinsic value. In fact, the entire value of an OTM option is extrinsic value because these options have no intrinsic value.

Yes, even ITM options have extrinsic value, as there is still uncertainty whether the option will remain ITM at expiration. As time passes, extrinsic value goes to zero and options that are deep ITM or OTM lose extrinsic value first, where ATM options hold onto value due to this uncertainty of where the option will be at expiration.

• In the options world, intrinsic and extrinsic value together represent the total value, or premium of an option
• The intrinsic value of an in-the-money (ITM) option at expiration is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero
• Extrinsic is the term used for the value of an option beyond its intrinsic value. Stated differently, extrinsic value is the part of the option premium that is not intrinsic value
• Extrinsic value is sometimes referred to as “time value” because it reflects the possibility that an option may become ITM before expiration