Options Intrinsic Value
Intrinsic value is the amount by which an options contract is in-the-money (ITM). It represents the tangible value that an options holder would gain if the contract were exercised immediately. For put options, intrinsic value is the difference between the strike price and the underlying asset's current price. If an options contract is out-of-the-money (OTM) or at-the-money (ATM), it has no intrinsic value since there would be no immediate gain from exercising the option.
What is Extrinsic Value?
Extrinsic value of an option is calculated by taking the difference between the market price of an option (also called the premium) and its intrinsic price – the value of an options contract in relation to the underlying at expiration or if exercised.
In other words, it is determined by factors other than the price of the underlying security and is the portion of an option’s price that exceeds its intrinsic value.
Calculating Extrinsic and Intrinsic Value:
To calculate extrinsic value, subtract the intrinsic value from the total options premium.
Extrinsic value = Total Options Premium - Intrinsic Value.
The intrinsic value is determined by comparing the current price of the underlying asset to the strike price.
Significance in Options Trading:
Understanding extrinsic and intrinsic value is crucial for options traders. Extrinsic value represents the market's expectation of potential future price movements and can greatly influence an options contract's price. Traders seeking to profit from changes in the underlying asset's price before expiration focus on maximizing extrinsic value. In contrast, intrinsic value provides a safety net for options holders, ensuring a minimum value based on the in-the-money amount.
Factors Impacting Extrinsic and Intrinsic Value:
Several factors influence extrinsic and intrinsic value:
a. Time Remaining: Extrinsic value is directly affected by the time remaining until expiration. As expiration approaches, extrinsic value diminishes rapidly.
b. Implied Volatility: Higher implied volatility generally leads to increased extrinsic value, as greater price swings are anticipated. Lower implied volatility can decrease extrinsic value.
c. Interest Rates: Changes in interest rates can impact extrinsic value, with higher rates potentially increasing the value and lower rates potentially decreasing it.
d. Market Conditions: Market conditions, including supply and demand dynamics and overall market sentiment, can influence both extrinsic and intrinsic value.
Intrinsic Value vs. Extrinsic Value
In options trading, the intrinsic price is the value any given option will have if it was exercised today and is calculated by taking the difference between the market price and strike price of the underlying security.
An in-the-money (ITM) option only has an intrinsic value. If the market price at expiration is greater than the strike price, the call option is in-the-money or profitable, and if the market price is lower than the strike of the put option, the put is profitable. Thus, if an option is at the money or out of the money, its intrinsic value is zero.
Intrinsic Value (Call Options) = Underlying Price – Strike Price
Intrinsic value (Put Options) = Strike Price – Underlying Price
Several factors like implied volatility, interest-free rate, time decay, etc. determine the option’s extrinsic value. The longer the time an option has until expiration, the higher its extrinsic value will be. As the expiration approaches, the extrinsic value of an option decreases and it becomes worthless as it expires.
For example, an options contract expires in 60 days and is out-of-the-money; it has no intrinsic value. It has a greater extrinsic value than an option expiring in 21 days, with all else being equal as there is more time, and therefore a higher chance for the 60-day option to move from out-of-the-money to in-the-money.