Extrinsic value is the difference between an option’s market price, known as the premium, and its intrinsic value. Extrinsic value reflects the factors outside of the price of the underlying asset. This value changes over time based on the time to expiration and the volatility of the underlying asset.
Read on to learn how extrinsic value works, the factors that affect it, and more.
Defining Extrinsic Value
So, how do we define extrinsic value? Extrinsic value is composed of variables other than the underlying asset price. The intrinsic value is a straightforward calculation: It is simply the difference between an option’s strike price and the price of the underlying asset when the underlying asset is in-the-money. An out-of-the-money option has no intrinsic value.
Remember, an option is “in the money” would be profitable for the owner to exercise today, while it’s “out of the money” if the owner would lose money if they exercised their option today. An out-of-the-money option may present an investment opportunity because of its potential for the option to become in-the-money at expiration.
As expiration approaches, extrinsic value usually diminishes. So, for example, an option that has two weeks before expiry will have a higher extrinsic value than one that’s one week away. Extrinsic value equals the price of the option minus the intrinsic value.
Out-of-the-money option premiums are entirely made up of extrinsic value while deep-in-the-money options often have a small proportion of extrinsic value. Options that trade at-the-money might have a substantial proportion of extrinsic value if there is a long time until expiration and if volatility is high. On the other hand, a short-dated at-the-money option would likely feature little extrinsic value.
How Extrinsic Value Works
Beginners sometimes have a tough time grasping the extrinsic value concept. Simply put, the more time until expiration and the more a share price can fluctuate, the greater an option’s extrinsic value.
Factors that Affect Extrinsic Value
Two factors affect an option’s extrinsic value: contract length and implied volatility. In general, the longer the contract, the greater the extrinsic value of an option. That ‘s because the more time allowed until expiration, the more a stock price might move in favor of the holder. Options have the potential to be worth more money the more the underlying asset price varies.
The second factor that goes into extrinsic value is implied volatility. Implied volatility measures how much a stock might move over a specific period. It’s measured by the options Greek, vega.
1. Length of Contract
An option contract generally has less value the closer it is to expiration. The logic is that there is less time for the underlying security to move in the direction of the option holder’s benefit. As the time to expiration shortens, the extrinsic value decreases, all else equal.
The time to expiration is a key variable for traders. Suppose a trader bought a put option at-the-money with just one week left until expiration. That put option’s extrinsic value will likely decline more quickly than would an option with several months until expiration since there is less time for the underlying share price to decline.
To manage this risk, many investors use the options trading strategy of buying options with varying contract lengths. As opposed to standard option contracts, a trader might choose to buy or sell weekly options which usually feature shorter contract lengths. On the opposite side of the spectrum, Long-Term Equity Anticipation Securities (LEAPS) sometimes have contract lengths that measure in years. Extrinsic value could be a large piece of the premium of a LEAPS option.
Some traders will also use a bull call spread, in order to reduce the impact of time decay (and the loss of extrinsic value) on their options.
Recommended: Guide to Options Spreads: Definitions and Types
2. Implied Volatility
Implied volatility measures how much analysts expect an asset’s price to move during a set period. In general, higher implied volatility means more expensive options, due to higher extrinsic value. That’s because there is a greater chance a stock price will significantly move in the favor of the owner by expiration. High volatility gives an out-of-the-money option holder more hope that their position will go in-the-money.
So, if implied volatility rises from 20% to 50%, for example, an option holder benefits from higher extrinsic value (all other variables held constant). On the flip side, an out-of-the-money option on a stock with extremely low implied volatility has a lower chance of ever turning in-the-money.
3. Others Factors
Savvy traders might know that it is not just the length of the contract and implied volatility that affect the premium of an option.
• Time decay. Changes in time decay, or the rate at which time decreases an option’s value, can greatly impact the premium of near-the-money options, this is known as theta. Time decay works to the benefit of the option seller, also known as the writer.
• Interest rates. Even changes in interest rates, or gamma, impact an option’s value. A higher risk-free interest rate pushes up call options’ extrinsic value higher, while put options have a negative correlation to interest rates.
• Dividends. A stock’s dividend will decrease the extrinsic value of its call options while increasing the extrinsic value of its put options.
• Delta. An option’s delta is the sensitivity between an option price and its underlying security. In general, the lower an option’s delta, the higher it’s extrinsic value.
Extrinsic Value Example
Let’s say a trader bought a call option from their brokerage account on shares of XYZ stock. The premium paid is $10 and the underlying stock price is $100. The strike price is $110 with an expiration date in three months. Also assume there is a company earnings report due out in the next month.
Since the share price is below the call’s strike, the option is out-of-the-money. The option has no intrinsic value because it is out-of-the-money. Thus, the entire $10 option premium is extrinsic value, or time value.
As expiration draws nearer, the time value (otherwise known as time decay) declines. A trader long the call option hopes the underlying asset appreciates by expiration. A jump in the call option’s extrinsic value can also push its price higher.
Higher volatility, perhaps the earnings report or some other catalyst, might move an option’s vega higher. Let’s assume the stock has risen to $120 per share following strong quarterly earnings results. The call option trades at $11 immediately before expiration.
The call option’s intrinsic value is now $10, but the extrinsic value has declined to just $1 since there is little time to expiration and the earnings date volatility-driver has come and gone. In this case, the trader can sell the call for a small profit or simply hold through expiration.
Extrinsic vs Intrinsic Value
Extrinsic value reflects the length of the contract plus implied volatility while intrinsic value is the difference between the price of the stock and the option’s strike when the option is in the money.
|Extrinsic Value Factors (Call Option)||Intrinsic Value Factor (Call Option)|
|Length of Contract||Stock Price Minus Strike Price|
Extrinsic Value and Options: Calls vs Puts
Both call options and put options can have extrinsic value.
Extrinsic value for call options can be high. Consider that a stock price has no upper limit, so call options have infinite potential value. The more time until expiration and the greater the implied volatility, the more extrinsic value a call option will have.
Put options have a lower potential value since a stock price can only drop to zero. Thus, there is a limit to how much a put option can be worth — it is the difference between the strike price and zero. Out-of-the-money puts, when the stock price is above the strike, feature a premium entirely of extrinsic value.
Start Investing Today with SoFi
Understanding the fundamentals of intrinsic and extrinsic value is important for options traders. While intrinsic value is a somewhat simple calculation, extrinsic value takes a few more factors into consideration. Traders should make sure they understand all of these factors before they begin trading options.
It’s also possible to build a strong portfolio without using options at all. While SoFi does not offer options right now, the SoFi Invest® online brokerage is a great way for investors to start building a portfolio of stocks, exchange-traded funds, initial public offerings, and cryptocurrency.
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