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What Is Extrinsic Value?
Extrinsic value measures the difference between the market price of an option, called the premium, and its intrinsic value. The opposite of extrinsic value is intrinsic value, which is the inherent worth of an option.
Factors that influence extrinsic value include time until expiration and implied volatility. Extrinsic value is also referred to as “time value.” The time left until the option contract expires is one of the primary factors affecting the option premium. As it nears expiration, a contract loses value because there is less time for the security’s price to change. Extrinsic value comes into play with put options in options trading.
Key Takeaways
- Extrinsic value is the portion of an option’s worth determined by time and market factors, not the underlying asset’s price.
- The time left until expiration is a critical factor affecting an option’s extrinsic value, diminishing as expiration nears.
- Implied volatility influences extrinsic value; higher volatility increases it, while lower volatility decreases it.
- An option with intrinsic value trades at a premium, consisting of both intrinsic and extrinsic value components.
Understanding the Fundamentals of Extrinsic Value
Extrinsic and intrinsic values make up the cost or premium of an option. Intrinsic value is the difference between the underlying security’s price and the option’s strike price when it 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. The actual option may trade at $2.50, so the extra $0.50 is extrinsic value.
If a call option is valuable when the security’s price is below the strike price, its premium comes solely from extrinsic value. Similarly, a put option’s value comes only from extrinsic value when the security’s price is above the strike price.
Key Influences on Extrinsic Value
Extrinsic value is also known as “time value” because the time left until the option contract expires is one of the primary factors affecting the option premium. Typically, a contract loses value as it nears expiration since there is less time for the security’s price to change favorably. For example, an option with one month to expiration that is out of the money will have more extrinsic value than an out-of-the-money option with one week to expiration.
Another factor that affects extrinsic value is implied volatility. Implied volatility measures the amount an underlying asset may move over a specified period. If the implied volatility increases, the extrinsic value will increase. For example, if an investor purchases a call option with an annualized implied volatility of 20% and the implied volatility increases to 30% the following day, the extrinsic value would increase.
Example of Extrinsic Value in Options Trading
Assume a trader buys a put option on XYZ stock. The stock is trading at $50, and the trader buys a put option with a strike price of $45 for $3. It expires in five months.
At the time of purchase, that option has no intrinsic value because the stock price is above the strike price of the put option. Assuming implied volatility and the price of the stock stay the same, as the expiration date approaches, the option premium will move toward $0.
If the stock drops to $40, the option gains $5 in intrinsic value. If time remains before expiration, it might trade for $5.50, $6, or more due to the presence of extrinsic value.
Intrinsic value does not mean profit. If the stock drops to $40 and the option expires, the option is worth $5 because of its intrinsic value. The trader paid $3 for the option, so the profit is $2 per share, not $5.
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