Extrinsic Value Defined

Extrinsic Value

What is Extrinsic Value?

Extrinsic value is the difference between an option’s market price, known as the premium, and its intrinsic value. Extrinsic value is also the part of an option’s worth that has been allocated to it by variables other than the price of the underlying asset. The inverse of extrinsic value is intrinsic value, which is an option’s inherent worth.

IMPORTANT TAKEAWAYS:

  • Extrinsic value is the difference between an option’s market price, also known as its premium, and its intrinsic price, which is the difference between the strike price of the option and the price of the underlying asset.
  • Extrinsic value increases when market volatility grows.

Extrinsic Value Fundamentals

The cost or premium of an option is made up of extrinsic and intrinsic value. When the option is in the money, the intrinsic value is the difference between the underlying security’s price and the strike price.

For example, if a call option has a strike price of $20 and the underlying stock is trading at $22, the option has a value of $2. The real choice may be worth $2.50, therefore the additional $0.50 represents extrinsic value.

If a call option has value while the underlying security’s price is trading below the strike price, the premium is derived only from extrinsic value. If, on the other hand, a put option is worth anything while the underlying security’s price is trading above the strike price, the option’s premium is simply made up of its extrinsic value.

Extrinsic Value Influencing Factors

Extrinsic value is frequently referred to as “time value” since the time remaining before the option contract expires is one of the principal elements influencing the option premium. A contract loses value as it approaches its expiry date since there is less time for the underlying security to move positively. For example, an out-of-the-money option with one month to expiry will have a higher extrinsic value than an out-of-the-money option with one week to expiration.

Implied volatility is another aspect that influences extrinsic value. The amount an underlying asset may change over a given time period is measured as implied volatility. If the implied volatility rises, so will the extrinsic value. For example, if an investor buys a call option with a 20 percent annualized implied volatility and the implied volatility rises to 30 percent the next day, the extrinsic value rises.

Example of Extrinsic Value

Assume a trader purchases a put option on the stock XYZ. The stock is now trading at $50, and the trader pays $3 for a put option with a strike price of $45 on it. It has a five-month expiration date.

Because the stock price is higher than the strike price of the put option at the time of purchase, that option has no intrinsic value. Assuming that implied volatility and the stock price remain constant, the option premium will approach zero as the expiry date approaches.

The option will have intrinsic value if the stock falls below the put strike price of $45. For instance, if the price falls to $40, the option has an intrinsic value of $5. If there is still time until the option expires, it may trade for $5.50, $6, or even more since there is still extrinsic value.

Profit is not synonymous with intrinsic worth. If the stock falls below $40 before the option expires, it is worth $5 due to its intrinsic value. Because the trader paid $3 for the option, the profit per share is $2, not $5.

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Oliver Moore