You often hear that the value of an option tends to decay with time, but why does this happen? To understand the concept, you will need to learn more about the extrinsic value in options. This article breaks down the concept of option extrinsic value, known as “time value,” which captures the potential of an option to profit before it expires, and teaches you how to calculate extrinsic value of an option.
Key takeaways
- Extrinsic value in options is the value beyond the intrinsic value and is also known as “time value.” This value represents the potential for an option to become in-the-money (ITM) before expiration.
- The extrinsic value in options will change based on various factors, such as time to expiration, implied volatility, interest rates, and dividends.
What Is an Option Extrinsic Value?
You can think of an option’s extrinsic value as the part of an option’s price that goes beyond its basic worth. Simply put, it’s the extra cost you’re paying for the potential of the option to become more valuable over time. This is different from the intrinsic value of an option, which is what the contract would be worth if it were exercised right now.
The extrinsic value in options plays a big role in how traders make money. It’s influenced by factors like how much time is left until the option expires and how volatile the market is. The more time to expiration and volatility there are, the higher the extrinsic value. This is because there’s a greater chance that the option could turn in-the-money (ITM) by the time it expires.
To figure out the extrinsic value, you first need to know the intrinsic value of an option. For call options, this is how much the current price of the asset is above the strike price. For puts, it’s how much the strike price is above the current asset price. Subtract the option’s intrinsic value from its current market price, and you have the extrinsic value.
Why does this matter to you? If you’re trading options, understanding extrinsic value helps you see not just what an option is worth now, but what it could be worth. For instance, if an option has a high extrinsic value, it may be more likely to become profitable at some point before expiration. This can influence your decisions about which options to buy or sell.
To simplify the calculation of the extrinsic value, we have created the table below based on our discussion above:
The Extrinsic Value of a Call Option
As counterintuitive as it may sound, to find the extrinsic value of a call option, we need to find its intrinsic value. This is the underlying asset’s current price minus the strike price of the option. Once we have this figure, subtracting it from the option’s market price will give you the extrinsic value.
When trading options, whether a call option is in-the-money (ITM) or out-of-the-money (OTM) significantly affects its extrinsic value. ITM options, which already hold intrinsic value due to the underlying asset’s price exceeding the strike price, still carry extrinsic value. This is because there’s uncertainty about the option’s status at expiration.
However, this extrinsic value in options erodes itself as the expiration date approaches, a phenomenon known as time decay (in fact, consider that many tend to use “extrinsic value” and “time value” as synonyms). Conversely, OTM options, lacking intrinsic value, consist exclusively of extrinsic value.
Therefore, here is the extrinsic value formula for a call option:
- ITM calls = Option market price – (stock price – strike price)
- OTM calls = Option market price
You can easily understand that the operation always requires you to compute the option market price minus the intrinsic value of an option. However, since OTM options do not have any intrinsic value, this operation becomes extremely easy in that case.
The Extrinsic Value of a Put Option
The put case is not any harder than the call scenario we described in the previous section. To determine the extrinsic value in options for a put contract, we first need to calculate, once again, its intrinsic value. This value is the strike price minus the current price of the underlying asset. If the result is negative, the intrinsic value is considered zero, as a put option’s intrinsic value can’t be less than zero (as you may guess, this would be the OTM case).
Once the intrinsic value is established, finding the extrinsic value in options becomes really straightforward. Simply take the option’s market price minus its intrinsic value. This difference is the extrinsic value, which accounts for factors like time until expiration and volatility, indicating the option’s potential to end up being in-the-money by the time it expires.
ITM put options, where the strike price is above the stock price, tend to have a higher extrinsic value due to the increased likelihood of profit before the option expires. Conversely, OTM put options, with the stock price above the strike price, exhibit lower extrinsic value, reflecting the reduced chance of profitability (in this sense, we’re using “profitability” in the sense of “ending up being in-the-money”).
Once again, we have this extrinsic value formula for puts:
- ITM puts = Option market price – (strike price – stock price)
- OTM puts = Option market price
What Is the Difference Between Extrinsic and Intrinsic Value?
We’ve mentioned both intrinsic and extrinsic value in options earlier in the text. It is probably wise to take a step back and clearly distinguish between the two in the context of options trading to understand the concept of intrinsic vs extrinsic value. Intrinsic value is essentially the real, tangible value of an option, determined by the difference between the underlying asset’s current price and the strike price of the option. For instance, using stock ABC as an example, if you have a call option with a strike price of $50 and the stock is currently trading at $55, the intrinsic value is $5.
However, a $5 intrinsic value does not mean that the option’s price will be $5. In fact, let’s say that this ITM call is currently trading at $7. Why is that?
To give you an answer, consider that the extrinsic value is always part of the picture here. The extrinsic value in options captures the extra value above this intrinsic measure, often referred to as the “time value.” It accounts for the potential of the option to increase in value before its expiration date. Continuing with the stock ABC example, if the call option is priced at $7 on the market, its extrinsic value would be $2, calculated by subtracting the intrinsic value ($5) from the market price of the option ($7).
This distinction is crucial because it highlights how options are valued not just based on current market conditions but also on future possibilities. The extrinsic value is influenced by factors such as time remaining until expiration, implied volatility, interest rates, and dividends, which all play a role in determining the premium of an option.
Now that you know the difference of intrinsic vs extrinsic value, let’s take a look at another common doubt on the matter: do these two values influence each other?
What Is the Relationship between Extrinsic Value and Intrinsic Value?
You should now perfectly know the difference of intrinsic vs extrinsic value in options, but understanding how these two concepts interrelate in options trading can further improve your strategies.
Once again: intrinsic value is what an option would be worth if it were exercised right now, based on the current price of the underlying asset relative to the strike price. Extrinsic value, or time value, on the other hand, accounts for the additional value an option holds due to the potential for its intrinsic value to increase before expiration.
In options trading, the total value of an option is the sum of its intrinsic and extrinsic values. An option’s premium is not merely a reflection of its current worth (intrinsic value) but also incorporates factors like time until expiration, implied volatility, interest rates, and expected dividends, all of which feed into the extrinsic value.
For example, options with longer expiration are generally priced higher, primarily because their extrinsic value is greater; there’s more time for the option to end up being in-the-money by the time they reach their expiration date.
Moreover, as the expiration date approaches, the extrinsic value decreases, a phenomenon known as time decay, highlighting the temporal nature of options. Theoretically, at the exact time of the expiration, your options will only have an intrinsic value.
This means that an ITM value will only be worth its intrinsic value, while an OTM option will be worthless (in fact, this is what makes option selling so appealing).
Do intrinsic and extrinsic values influence each other? Technically, this will not be the case, as both values are determined based on different factors. What you should keep in mind is that, while independent, they both concur on the final price of an option. The intrinsic value determines a minimum price, while the extrinsic values give an edge to this base amount.
How to Calculate the Extrinsic Value of an Option?
Before we finish, let’s check out two examples using real market data to learn how to calculate the extrinsic value of an option. This will show us how the value of an option can change in different market situations.
Let’s look at a call option for Tesla (TSLA), which is now priced at $166.11. We will examine two options that have different strike prices but share the same expiration date.
Extrinsic Value Example 1: ITM Call on TSLA
Through our options screener, we could find a call option with a strike price of $162.5, with its bid and ask prices at $7.20 and $7.30, respectively.
To determine the intrinsic value, we deduct the strike price from the stock price, resulting in $166.11 – $162.5 = $3.61. This figure represents the intrinsic value of the option. The rest of the premium, which is $3.64 at the bid-ask spread’s midpoint, constitutes the extrinsic value in options, which diminishes over time. This extrinsic value example perfectly shows you that even the simple market price of an option can give you a great deal of information on a trade.
Extrinsic Value Example 2: OTM Call on TSLA
Now, consider a call option for TSLA at a strike price of $170. This option isn’t in the money right now. Its bid and ask prices are between $3.45 and $3.50. This makes it a cheaper option compared to the in-the-money option we talked about earlier.
So, how to calculate the extrinsic value of an option that is out-of-the-money? In this scenario, the option holds no intrinsic value as the stock price is beneath the strike price. The total premium simply represents the extrinsic value in options that are OTM.
What did we learn from these examples? Just like we mentioned in the theoretical part of the article, we have that:
- ITM options hold intrinsic values and extrinsic values.
- OTM options only have extrinsic value.
- Extrinsic value in options diminishes as a contract nears its expiration date.
- To compute the extrinsic value in options, you simply apply the extrinsic value formula (total premium minus the intrinsic value of an option).
