What is extrinsic value?
Extrinsic value refers to the difference between the premium and intrinsic value. And when we say premium, we refer to the option market price. Extrinsic value also talks about a worth’s portion assigned to options depending on many factors aside from the underlying asset’s price. We already mentioned the term “intrinsic value” earlier. It is the opposite of extrinsic value, and it tells us the inherent worth of an option.
Citing an example to explain how it works
If we ought to enumerate what makes up the cost of an option’s premium, it is the combination of its extrinsic and intrinsic value. Now when we say intrinsic value, it refers to the difference between the option’s strike price and underlying security’s price when the option is “in the money.”
Let us say that a call option’s strike price is $30, and the underlying stock trades at $35. What is the intrinsic value of the option in this case? It should be $5. However, the actual option may be trading at $6. So, it means that the extra $1 is our extrinsic value.
Now, what if the call option has a value and the underlying security’s price trades lower than the strike price? The premium will then stem from the extrinsic value. Let us look at it the other way around, where the put option has a value and the underlying security’s price trades higher than the price. If this is the case, then the option’s premium will come from its extrinsic value.
What makes an impact on extrinsic values?
If you have heard of the term “time value,” and it gets associated with extrinsic value, you are not mistaken. It is also called time value because the remaining time left before the contract’s expiration is one of the most significant factors makes a massive impact on the option premium. Usually, a contract declines in value as it gets closer to the expiration date since the remaining time gets lesser for it to make a significant and favorable move. For instance, an out-of-the-money option is about to expire in a month. It means that it has more extrinsic value than an out-of-money option’s extrinsic value that is about to expire in a week.
Aside from time, another factor that significantly impacts the extrinsic value is the implied volatility. It gauges how much an underlying asset can move in a given time frame. If the implied volatility increases, the extrinsic value will also increase. For instance, you bought a call option with a 20% implied volatility every year. If it increased to 25% tomorrow, it would have more extrinsic value.
Let us have a recap
Today, we learned a lot about extrinsic value. It refers to the difference between the option’s market price, also known as premium, and the intrinsic price. Intrinsic price is the difference between the underlying asset’s price and the option’s strike price. If the extrinsic value increases, the market volatility will also increase.