Extrinsic Value
The difference between the market price of an option and its intrinsic price
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What is Extrinsic Value?
Extrinsic value of an option is calculated by taking the difference between the market price of an option (also called the premium) and its intrinsic price – the value of an options contract in relation to the underlying at expiration or if exercised.
In other words, it is determined by factors other than the price of the underlying security and is the portion of an option’s price that exceeds its intrinsic value.
Summary
- Extrinsic value of an option is calculated by taking the difference between the market price of an option (also called the premium) and its intrinsic price – the value of an options contract in relation to the underlying at expiration or if exercised.
- A contract generally loses value as it approaches its expiration date because there is less time for the underlying security to move in favor of the holder.
- If volatility in an underlying security increases, the extrinsic value of the option will also increase and vice-versa.
Factors Affecting Extrinsic Value
1. Length of the Contract
One of the primary factors that affect extrinsic value is the length of the contract. A contract generally loses value as it approaches its expiration date because there is less time for the underlying security to move in favor of the holder. Hence, it is justifiable on the part of the holder to pay more in extrinsic value for options with longer expiration.
For example, an option with one month to expiration that is out of the money will have a greater extrinsic value than that of an out of the money option with one week to expiration.
2. Implied Volatility
Implied volatility (also known as vega) measures the amount an underlying asset may move over a specified period. When volatility is added to the time value, the extrinsic value of an option is obtained.
If volatility in an underlying security increases, the extrinsic value of the option will also increase and vice-versa. For example, if an investor purchases a call option with an annualized implied volatility of 10% and the implied volatility increases to 35% the following day, the extrinsic value will increase.
Intrinsic Value vs. Extrinsic Value
In options trading, the intrinsic price is the value any given option will have if it was exercised today and is calculated by taking the difference between the market price and strike price of the underlying security.
An in-the-money (ITM) option only has an intrinsic value. If the market price at expiration is greater than the strike price, the call option is in-the-money or profitable, and if the market price is lower than the strike of the put option, the put is profitable. Thus, if an option is at the money or out of the money, its intrinsic value is zero.
Intrinsic Value (Call Options) = Underlying Price – Strike Price
Intrinsic value (Put Options) = Strike Price – Underlying Price
Several factors like implied volatility, interest-free rate, time decay, etc. determine the option’s extrinsic value. The longer the time an option has until expiration, the higher its extrinsic value will be. As the expiration approaches, the extrinsic value of an option decreases and it becomes worthless as it expires.
For example, an options contract expires in 60 days and is out-of-the-money; it has no intrinsic value. It has a greater extrinsic value than an option expiring in 21 days, with all else being equal as there is more time, and therefore a higher chance for the 60-day option to move from out-of-the-money to in-the-money.
Why are Extrinsic Values for Call and Put Options Different?
The extrinsic values of call (right to buy) and put (right to sell) options of the same strike price – also known as the exercise price – are usually different. Even though higher interest rate results in higher extrinsic value for call options, it actually results in lower extrinsic value for put options.
Similarly, even though dividends decrease the extrinsic value of call options, they increase the extrinsic value of put options due to certainty that the stock will go down.
Call and put options of the same stock usually have different extrinsic values because a stock is going upwards or downwards. As a result, investors are buying more call options or put options. In that situation, the extrinsic value of that type of options increases due to increased trading.
Related Readings
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