What is Extrinsic Value?

What is Extrinsic Value?

Let me explain extrinsic value to you directly: it's the difference between the market price of an option, which we call the premium, and its intrinsic value. I see it as the part of the option's worth that comes from factors beyond just the underlying asset's price. Remember, this is the opposite of intrinsic value, which is the built-in worth of the option.

Basics of Extrinsic Value

You need to know that extrinsic value and intrinsic value together make up the cost or premium of an option. Intrinsic value is simply the difference between the underlying security's price and the option's strike price when the option is in the money.

Take this example: if a call option has a strike price of $20 and the underlying stock is at $22, that option has $2 of intrinsic value. But the actual option might trade at $2.50, meaning the extra $0.50 is extrinsic value.

If a call option still has value even when the underlying security's price is below the strike price, that premium comes entirely from extrinsic value. On the flip side, for a put option with value when the underlying is above the strike, the premium is all extrinsic value.

Factors Affecting Extrinsic Value

I often call extrinsic value 'time value' because the time left until the option expires is a key factor in the premium. Under normal conditions, the contract loses value as expiration nears, since there's less time for the underlying security to move in your favor. For instance, an out-of-the-money option with one month left has more extrinsic value than one with just a week to go.

Another major factor is implied volatility, which gauges how much the underlying asset might move in a given period. If implied volatility goes up, so does the extrinsic value. Say you buy a call option with 20% annualized implied volatility, and it jumps to 30% the next day—that extrinsic value increases right away.

Extrinsic Value Example

Let's walk through an example: suppose you buy a put option on XYZ stock. The stock is at $50, and you get a put with a $45 strike for $3, expiring in five months.

At purchase, there's no intrinsic value because the stock price is above the strike. If implied volatility and stock price stay the same, the premium heads toward $0 as expiration approaches.

But if the stock drops below $45, say to $40, the option gains $5 in intrinsic value. With time still left, it might trade at $5.50, $6, or more, thanks to remaining extrinsic value.

Keep in mind, intrinsic value doesn't equal profit. If the stock hits $40 at expiration, the option is worth $5 intrinsically. You paid $3, so your profit is $2 per share, not $5.