What is Extrinsic Value In Options Trading?
The extrinsic value of a stock option contract is the portion of the option’s worth that has been assigned to factors other than the underlying asset’s price, for example implied volatility and time to expiry.
Stock Options: Extrinsic And Intrinsic Value
The value of an option is determined by the difference between its intrinsic and extrinsic values. The intrinsic value of a call option is equal to the strike price minus the current market price of the underlying asset, while the intrinsic value of a put option is equal to the current market price of that asset plus the strike price.
In general:
Option Price = Intrinsic Value + Extrinsic Value
And so the formula for extrinsic value is:
Intrinsic Value Definition
The intrinsic value of an option is the price at expiration, assuming that the option expires today and is exercised.
In other words it is the current stock price less the option exercise price. It is zero if the stock price is less than the option’s strike price.
Extrinsic And Intrinsic Value Example
Suppose a share’s price is $100 and a 3 month $80 call option is trading at $25.
Then it’s intrinsic value = $100 – $80 = $20
And so using Option Value = Intrinsic Value + Extrinsic Value, gives:
Extrinsic Value = $25 – $20 = $5
Extrinsic Value: Detailed Explanation
The extrinsic value of an option is defined as everything outside of the underlying asset itself. This includes things like dividends, interest rates, and news events. What makes something extrinsic is that it isn’t directly related to the underlying asset. For example, a stock dividend doesn’t affect the price of the underlying shares; it affects the price of the options contract.
Intrinsic value refers to the underlying asset itself, such as the price of a stock or bond. Intrinsic values are calculated based on the current market prices of those assets.
An option is considered “in the money” when the underlying asset is trading above the strike price. When the underlying asset is trading below the strike price, the option is considered “out of the money.”
The intrinsic value of an option depends upon whether the option is “deeply in the money” or “shallowly in the money.” Deeply in the money options tend to trade near $100 per share. Shallowly in the money options trade closer to $50 per share.
A deep-in-the-money option can provide investors with a way to profit from rising prices. A shallow-in-the-market option can offer a way to profit from falling prices.
Factors Affecting Extrinsic Value
Time Until Expiration
The main determinant is the time remaining until the option expires, and hence the time value of the option.
As the expiration date approaches, the option becomes increasingly difficult to sell because fewer people want to purchase them. This leads to lower prices, which reduces the overall value of the option.
Moneyness
Another major factor that influences extrinsic value is whether the option is in-the-money (ITM) or out-of-the-money (OTM). An option that is out of the market is considered to be worthless because no one wants to buy it.
However, an option that is in-the-money could still be worth something even though it does not provide a guaranteed profit.
Implied Volatility
Implied volatility is another important factor that determines extrinsic value. When implied volatility rises, the extrinsic values of the options rise accordingly.
Higher implied volatilities lead to greater demand for options, due to the volatility of the underlying, resulting in higher prices.
Others Factors
The length of the contract and the implied volatility are important factors in determining the premium of an option; however, there are many others factors that can influence the price of an option.
These gamma, interest rates and even the underlying security itself.