Extrinsic value is one of the moving parts in options trading. Extrinsic value is, in essence, value from the outside. Options give you the right but not the obligation to buy or sell a stock at a specified price.
One options contract controls 100 shares of a stock. In essence, trading options is cheaper than trading shares. However, because there are more moving parts to options trading there is the possibility to more loss.
Although, with the possibility of more profit loss, there’s also the potential to profit much more than buying shares. The flip side is that because options are cheaper than shares, you’re not spending as much money to make the trade.
Extrinsic value measures the difference in the price of the options, also known as the premium, and intrinsic value. 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 worth besides the strike price. Whereas intrinsic value is the inherent worth of an options contract.
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.
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. In fact, allowing emotions to control your trading is the perfect way to blow up your brokerage account.
EXTRINSIC VALUE – BREAKING IT DOWN
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, lets 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.
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 extrinsic value.
EXTRINSIC VALUE – WHAT AFFECTS IT?
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 extrinsic value. Implied volatility maps out how much a stock can move in a certain amount of time. Read our post about the implied volatility formula.
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.
EXTRINSIC VALUE – DIRECTION MATTERS
There are many different ways to make money trading options. Spreads are the safest way to trade them especially if you’re trading options for a living. However, you can day trade options which can be a great way to make a profit without putting up a lot of capital.
Choosing the right direction matters; especially with the different parts of options that affect price. Buying or selling a put when a stock is bullish is a great way to lose money and visa versa.
In order to chose the correct direction, you have to know candlesticks and patterns. That is a foundation of trading. Without candlesticks, technical analysis wouldn’t mean anything.
EXTRINSIC VALUE – THE BOTTOM LINE
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. Take our options trading course to learn about what makes up options profit and loss.
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