Extrinsic value is one of the main components of 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 of options. Extrinsic value is, in essence, value from the outside.
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. EV has other factors that make up the value of an option besides the strike price. At the same time, intrinsic value is the inherent worth of an option contract. Selling options instead of buying them is a very profitable strategy to learn.
What Is Options 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 the intrinsic value from the price of an options contract. However, intrinsic and extrinsic value make 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. The option writer takes on unlimited risk by creating the option. The buyer of that option has limited risk with unlimited profit potential.
You would have to buy or sell naked calls or puts to have unlimited profit potential. 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.
Risk Premium Breakdown
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 option’s intrinsic value is $0.75, and the extrinsic value is $1.64. This process becomes easier to learn the more you paper-trade options.
That options contract is in the money. The money for a call option means the strike price is below the market price. As a result, a call option has value when a stock is trading below the strike price; the premium you’re paying comes from the EV.
There’s also the bearish side to that: put options. If a put option has value when a stock trades above the strike price, the option premium comprises the EV.
Extrinsic Value Example
This is an example of extrinsic value on the ThinkorSwim platform. The columns are customizable so that you can add columns such as volume, open interest, strike price, probability ITM, probability OTM, and the Greeks, delta, gamma, theta, and vega.
The options chain is simple to read on most trading platforms. There’s also the ability to look at an options chart.
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 expire on an options contract affects its price. Normally, a contract loses value the closer to expiration it gets. That’s why options contracts closest to your purchase date 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 a couple of months from expiration has more EV than one with five days to expiration.
Implied volatility is another factor that affects EVs. Implied volatility maps out how much a stock can move in a certain amount of time.
The more implied volatility increases, the more the EV 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 whether you’ve made the correct trade.
Extrinsic Values for Calls and Puts
Did you know that the extrinsic values of call (right to buy) and put (right to sell) options with the same strike price – also known as the exercise price – can differ? While call options benefit from higher interest rates through an increase in EV, put options are negatively affected and experience a decrease in extrinsic value.
Despite reducing the extrinsic value of call options, dividends tend to raise the extrinsic value of put options by ensuring that the stock will experience a decline.
The extrinsic values of call and put options for a particular stock generally differ, depending on whether the stock is rising or falling. Due to this, investors tend to purchase more call or put options, thus increasing the EV of these options due to the heightened trading activity.
Greatest Options Trade of All Time
Legend has it that in 1987, a trader mistakenly believed he had purchased one put option on the S&P 500. However, it turned out that he had bought 1,000 put options instead. This fortunate mistake earned him a profit of well over $10 million!
Key Takeaways
- Extrinsic value measures the difference between the market price of an options contract, which is the premium, and its intrinsic value.
- Contracts tend to lose value as they near their end date. This is because there is less time for the prices of securities to move in the holder’s favor.
- The volatility of the underlying security has a direct impact on the EV of an option. If the volatility in the underlying security goes up, the option’s extrinsic value will also go up. And if the volatility decreases, the option’s extrinsic value will also decrease.
- Generally, options with longer expiration dates have higher extrinsic values than options with shorter expiration dates.
- Even when two options have the same strike price and intrinsic value, the EV differs due to their different expiration dates.
Final Thoughts: Extrinsic Value
Many different factors affect the extrinsic value of options contracts. The Greeks comprise a large component, especially theta, aka time decay. Other factors include economic news, company news, and global economic events.
Extrinsic value makes up an option’s 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.
Frequently Asked Questions
MCD has an expiration date of January 19, 2024. The extrinsic value is $3.19 on the $295 strike price. This means that the options contract loses $3.19 of extrinsic value each day until expiration.
Intrinsic value refers to the in-the-money (ITM) portion of an options contract. Extrinsic value refers to the out-of-the-money (OTM) portion of an options contract.
Yes, extrinsic value can be negative. This occurs when an option's overall premium is lower than its intrinsic value. The option's negative extrinsic value indicates that market factors, such as low volatility or short time to expiration, have diminished its time value component.
In options trading, extrinsic value is calculated by subtracting the market price of an option (a.k.a. its premium) from its intrinsic value.
