Extrinsic value is obtained by subtracting an option’s market price and intrinsic value.
It can be defined as an item’s value outside its intrinsic value. This value comes from the amount of money assigned to assets.
External factors like the appearance and size of an item must be considered when measuring the extrinsic value of an item.
Extrinsic Value Example
An option has two components, i.e., extrinsic value and intrinsic value. When an investor purchases an option, the determined exercise is equal to or lower than the underlying option’s spot price. It means the intrinsic value is 0.
When the spot price at maturity is larger than the exercise price, the option is believed to have a positive payoff. The investor is required to pay a premium to purchase the option even if the intrinsic value is 0.
Suppose the spot price of the underlying asset is either $100 or less and the exercise price for the option is $100, then the payoff is 0. But if the spot piece becomes $110 during the option, then the payoff is $10 ($110-$100).
If the option has three months to expire, it can be assumed that the underlying asset can go up to $120. The option price will get higher from the current payoff in such a case. This additional value is a result of extrinsic value.
Basics of Extrinsic Value in Strike Price
The premium or cost of an option comprises extrinsic and intrinsic values. Here, the intrinsic value is defined as the difference between the option’s strike price and the underlying security price when the option is in the money.
Extrinsic Value and Options: Calls vs. Puts
Both the call and put options are known to have extrinsic value in options trading.
Comparatively, call options are seen to have higher extrinsic value. Call options are believed to have infinite potential value considering a stock price has no upper limit. If the expiration time is more, volatility is more. As a result, options will have better extrinsic costs.
As stock prices can drop to zero, put options are believed to have lower potential value. Traders need to remember that there is a limit to how much a put option can be worth (considering the difference between the strike price and zero).
Intrinsic Value of an Option in Market Price
The current value of an option is its intrinsic value, i.e., ITM. An option has a positive payoff for the buyer if it’s in the money. For instance, a call option with $30 on a $40 stock will have $10 in the money.
At this point, if a buyer exercises the option, he might buy the stock at $30 and sell it at $40 on the market, with a $10 payoff. The amount that the buyer will receive if he exercises the option right now is represented by intrinsic value. The difference between an option’s current and the strike price tells the intrinsic value of options ITM.
The intrinsic value for options at-the-money or out-of-the-money is always 0. It happens because a buyer is not likely to exercise an option that might result in loss. Instead, a buyer will get no payoff by letting the option expire. As the buyer gets no payoff, intrinsic value is 0 for him.
Intrinsic Value vs. Extrinsic Value
Any given option would have an intrinsic value if it were exercised today. This value is calculated by subtracting the difference between the market price and the strike price of the underlying security.
If the strike price of an asset is lower than the market price, then the call option is believed to be in the money, which is profitable. Similarly, the put option becomes profitable if the market price is less than the strike price. It means the intrinsic value of options ITM and OTM is 0. Only in-the-money options have intrinsic value.
An option’s extrinsic value is determined by multiple factors, like volatility, interest-free rate, time decay, and more. The extrinsic value will be higher if the option has a long time until expiration. An option’s extrinsic value drops as expiration approaches. So, when an option expires, its value becomes 0.
Let’s assume an option is out-of-the-money and will expire in two months. Currently, it has no intrinsic value. Since expiration time is more, this option will have more extrinsic value than one option that might be expiring in a month. For this reason, an option with two months expiration date has a better probability of moving from out-of-the-money to in-the-money.
Therefore, only intrinsic value is worth considering when an option is about to reach its expiration. Using intrinsic value, you can determine whether you can sell or buy underlying asset at a better price than the market price.
How Does Extrinsic Value Work?
The extrinsic value acts as an important meter that helps know an item’s price. One can determine the extrinsic value by determining the difference between an asset’s premium and intrinsic value. Similarly, intrinsic value can be figured out by subtracting the option’s strike price and the underlying price.
How Extrinsic Value is Determined
Different factors impact an option’s extrinsic value. The first obvious factor is whether the option is ITM, ATM, or OTM. In addition, by how much the option is ITM vs. OTM. Options in the money have better extrinsic value.
The time left till the expiration of an option also impacts the extrinsic value. As a buyer, if your option has more time for expiration, the higher the extrinsic value and premium will be.
The option’s value goes down if the asset does not move in your favor. This phenomenon is called time decay. For this reason, an option with 1-week expiry has less extrinsic value than an option with 1 month of expiration date.
Implied volatility is the last parameter to determine an option’s extrinsic value. If a stock has higher volatility, investors will pay more. It drives up the stock’s price. The stock that is in demand is believed to have higher implied volatility.
Factors Affecting Extrinsic Value
An options extrinsic value is affected by implied volatility and contract length. A contract with a longer expiry time is believed to have greater extrinsic value. That’s because when an option has more time until expiration, the chances of the stock price moving in the holder’s favor is more.
Similarly, how much distance stock is likely to cover in a specific time is measured by implied volatility.
Here are factors affecting extrinsic value:
Length of Contract
If an option contract is closer to expiration, it would have less value. That’s because underlying security has less time to move in the direction that could benefit the holder. Hence, the extrinsic value of an item decreases as it moves closer to the expiration time.
Time to expiration is important. Let’s assume a trader has purchased a put option at the money four days before its expiration. Its extrinsic value will decrease faster than the option with a month until expiration in the coming days.
Traders use options trading strategies of buying options with varying contract lengths to manage this risk. A trader can sell or buy weekly options that have shorter contract lengths. On the other hand, the contract lengths measure in years for Long-Term Equity Anticipation Securities.
Many times, traders also try to reduce the impact of time decay using a bull call spread.
Implied volatility determines how much an asset’s strike price is predicted to move during a set period. If implied volatility is higher, the extensive value is also higher. Thus, the option becomes more expensive.
The chance of the stock price moving in favor of the expiration is higher. High volatility is better for traders with out-of-the-money options as they can expect the position to go to ITM.
If implied volatility rises, an option holder will benefit from the high extensive value. But a trader with an out-of-the-money option has a lower chance to turn ITM if implied volatility is low.
Besides the length of the contract and implied volatility, a few other factors affect the premium of an option.
- Time Decay: The rate at which an option’s value is decreased by time impacts the premium of near-the-money options. It’s called Theta. Time decay is beneficial for option sellers.
- Interest Rates: An option’s value is impacted by changes in the interest rate or Gamma. A higher risk-free interest rate pushes up a call option’s extinct value. On the other hand, put options negatively correlated to interest rates.
- Dividends: A stock’s dividend can increase the put option’s extrinsic value and decrease the call option’s extrinsic value.
- Delta: The sensitivity between underlying security and option price is the option’s Delta. An option with lower Delta has better extrinsic value.
Extrinsic Value and Time Value
As extrinsic value is higher for options with more expiry time, it is also called time value. But this time also justifies the additional risk an option’s seller takes. The option’s seller is at greater risk if the expiration time is more.
Traders need to remember that while “time” left in stock is a major determinant of extrinsic value, the extrinsic value is not determined by time.
Extrinsic value helps in knowing the amount of money that can justify the seller’s risk of an option.
The factors that come together to determine extrinsic value are:
- Time left to expiration (Theta)
- Changes in interest rate (Rho)
- The volatility of the underlying asset (Vega)
- Dividends of the underlying security
Time value is not an extrinsic value, but it’s one factor that influences the extrinsic value.
How Extrinsic Value Benefits Holder and Risks Sellers
Extrinsic value is known to be risky for sellers of the option. Here’s how extrinsic value justifies benefits received by holders and risks undertaken by sellers.
Time Left To Expiration
The options sellers are exposed to more risk if the opinion has a long time for expiration. When a trader sells a call option, and the underlying asset rises, the money is lost. But if a trader sells a put option and stocks keep falling, the losses build up. For this reason, sellers are paid more in extrinsic value.
More time left to expiration is beneficial for holders as the longer the time, the better the chances of stock moving in their favor.
Volatility Of The Underlying Stock
A volatile stock is likely to make big down or up moves. These stocks are likely to move in the opposite direction, causing a great loss to the sellers. If an option has higher implied volatility, its extrinsic value will also be higher. It compensates for the seller’s risk.
Whereas volatility is beneficial for buyers. The better the volatility is, the greater the chances of the stock moving in a favorable direction. This benefit justifies higher extrinsic value for buyers.
Dividends Of The Underlying Stock
Dividend-paying stocks will have lower call options extrinsic value. The stock’s price will be lower than the dividend amount when dividends are declared. The stock sellers get to keep the dividend paid by the stock instead of selling it outright. Due to this benefit, the extrinsic value is lower.
For holders, it’s a disadvantage. To reflect this, holders of the call options pay a lower extrinsic value.
Extrinsic value is the difference between an option’s market price, called premium, and its intrinsic value. For sellers, extrinsic value is not beneficial, but it brings great advantages for holders.
It is important to know the factors affecting extrinsic value, how this value is determined, and how it works.