Extrinsic value is one of the main components to options trading. It measures the difference between the market price of an options contract, which is the premium, and its intrinsic value. It is one of the moving parts in options. Extrinsic value is, in essence, value from the outside.
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What Is Extrinsic Value?
Extrinsic value measures the difference in the price of the options, also known as the premium, and intrinsic value. The extrinsic value is found by subtracting intrinsic value from the price of an options contract. However, both intrinsic and extrinsic value are what makes up the cost of an options contract.
Intrinsic value is the calculated value of a company. It’s found using tangibles and intangibles also known as fundamental analysis.
You can’t have extrinsic value without intrinsic value. They work hand in hand. Extrinsic value has other factors that make up an options value besides the strike price. Whereas intrinsic value is the inherent worth of an option contract. Selling options instead of buying them is a very profitable strategy to learn.
Risk Premium
You can also look at extrinsic value as the risk premium of an option. People like to define their risk right? The option writer takes on unlimited risk by creating the option. The buyer of that option has limited risk with unlimited profit potential.
To have unlimited profit potential, you would have to buy or sell naked calls or puts. However, strategies like spreads cut down on risk. They also put a cap on profit potential. That isn’t a bad thing though. You don’t need to hit a home run every single trade.
Breaking down extrinsic value ends up being a lot about intrinsic value. As stated above, they work in tandem. You can’t have one without the other because they make up the price of an option.
For example, let’s say you want to buy a call option with a strike price of $82. The stock is trading at 82.74 currently. The price of the contract is $2.46. The intrinsic value of the option is $0.75 and the extrinsic value is $1.64. This process becomes easier to learn the more that you paper trade options.
That options contract is in the money. In the money for a call option means that strike price is below the market price. As a result, is a call option has value when a stock is trading below the strike price, the premium you’re paying comes from the extrinsic value.
There’s also the bearish side to that; put options. If a put option has value when a stock is trading above the strike price, the option premium is made up of the EV.
Time Value
Did you know that extrinsic value is also known as time value? Time value is very important in an options contract. The time left to expiration on an options contract affects it’s price. Normally a contract loses value the closer to expiration it gets. That’s why options contracts closest to the date you’re purchasing are cheaper. As a result, you pay less money to place the trade.
However, your risk goes up a lot. The profit potential is limited as well. You want to purchase options contracts with a lot of time value. For example, an out of the money contract that is a couple months from expiration has more extrinsic value than one with 5 days to expiration.
Implied volatility is another factor that affects EV. Implied volatility maps out how much a stock can move in a certain amount of time.
The more implied volatility increases, the more the extrinsic value increases. As a trader, you want volatility. It means a stock is going to move. When a stock moves, you can profit or lose. It depends on if you’ve made the correct trade.
Factors
There are many different factors that affect the extrinsic value of options contracts. The Greeks make up a large component, especially theta aka time decay. Other factors include economic news, company news and global economic events.
Extrinsic value makes up an options premium. Time matters when opening a trade. Options have more moving parts than shares so make sure you take the time to study and understand how to trade them.
If you need more help, take our options trading course.
