The intrinsic and extrinsic value of an option make up the total value of the option, or the price paid for the option by the buyer to the seller.
It is important to understand what intrinsic and extrinsic value is in order to see how option contracts get their prices. This article will explain intrinsic and extrinsic value to prepare investors to make intelligent decisions when purchasing or selling option contracts.
The intrinsic value of an option is the difference between the market price and strike price of the underlying security. Let’s look at a couple examples of options having intrinsic value.
- Assume Nike, Inc. (NYSE: NKE) has a strike price of $80. If an investor owns a call option for NKE with a market price of $83, then it has an intrinsic value of $3, since the intrinsic value of the call option is the stock price less than the strike price. In this example, the option is “in-the-money.” By exercising his right on the option, the option owner could buy the shares at $80, then immediately sell the shares at $83. With this option, the owner can profit $3 per share.
If an investor owns a call option for NKE with a strike price of $85, but the market price of NKE is $83, then there is no intrinsic value. In this example, the call option is “out-of-the-money.”
- If an investor owns a put option for NKE with a strike price of $85, and NKE has a market price of $80, then it has an intrinsic value of $5. This is “in-the-money.” If the option owner exercises the option, then he could make a profit of $5 per share by buying the shares at $80, then immediately selling the shares at $85.
If an investor owns a put option for NKE with a strike price of $85, but the market price of NKE is $90, then there is no intrinsic value. Just like the call option, this is known as being “out-of-the-money.”
The farther “in-the-money” an option is, the higher the intrinsic value of the option will be. The higher the intrinsic value, the higher the price for the option.
If it is “out-of-the-money” by the expiration date, then it will expire and have no value. However, if it is “out-of-the-money” before the expiration date, then it still has value because of the extrinsic value.
The extrinsic value is made up of the time value and implied volatility of the option.
The time value of an option is dependent upon the length of time remaining before the option contract expires.
The more time an option has until expiration, the greater the extrinsic value is. As the option approaches its expiration date, the extrinsic value decreases. When the option expires, it becomes worthless.
Let’s look at example of an option having time value.
- An NKE option contract expires in 60 days and is “out-of-the-money.” This has a greater extrinsic value than a NKE option that expires in 21 days, with all else being equal. This is because 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.”
Now let’s look at the other side of extrinsic value, the implied volatility. Implied volatility indicates how volatile the underlying stock’s price may be in the future.
High implied volatility means that the stock is expected to have large price swings, either up or down. Low implied volatility means that the stock is expected not to swing in either direction significantly.
Higher implied volatility indicates a higher extrinsic value for the option. Conversely, a lower implied volatility indicates a lower extrinsic value.
Let’s look at an example of how an option’s implied volatility contributes to extrinsic value.
- If a NKE option has an implied volatility of 10% and the implied volatility increases to 30%, then the extrinsic value of the NKE option would also increase.
It is important to remember that the intrinsic value is made up of the difference between the market price and strike price of the underlying security. The extrinsic value is made up of the time value and implied volatility of the underlying security. When the intrinsic and extrinsic value of an option increases, then the total value of the option increases.
Understanding this concept of intrinsic and extrinsic value, and how these values come to be, will help investors decipher between good and bad option trades.