Extrinsic Value

Extrinsic means something existing outside of the scenario that it is being related to, but it can be something that influences that scenario. If we consider the scenario to be the totality of existence then because our perceptions and subsequent conceptual assessments are half of the subjective/objective equation, the extrinsic value would be a value that originates from outside of our perceptual/conceptual abilities. The capacity to conceptually abstract our surroundings and use logic evolved as part of our arsenal that was built to enhance sentience and physical agency. It did not evolve to accurately conceptualize a metaphysical assessment of that which is extrinsic to our restricted abilities.

The extrinsic value measures the difference between the market price of an option, called the premium, and its intrinsic value. Extrinsic value is also the portion of the worth that has been assigned to an option by factors other than the underlying asset’s price. The opposite of extrinsic value is intrinsic value, which is the inherent worth of an option.

Extrinsic Value and Intrinsic Value –

Extrinsic value, and intrinsic value, comprises the cost or premium of an option. Intrinsic value is the difference between the underlying security’s price and the option’s strike price when the option is in the money.

For example, if a call option has a strike price of $20, and the underlying stock is trading at $22, that option has $2 of intrinsic value. The actual option may trade at $2.50, so the extra $0.50 is extrinsic value.

If a call option has value when the underlying security’s price is trading below the strike price, the option’s premium only stems from extrinsic value. Conversely, if a put option has value when the underlying security’s price is trading above the strike price; the option’s premium is only comprised of its extrinsic value.

The intrinsic value when it comes to the options trading world is how much an option would be worth if it expired right now. If all the time on an option suddenly disappeared and it was exercised, how much would we make (not including additional fees)?

  • If you would make nothing ($0), the option would have no intrinsic value.
  • If you make money, the amount you would make would be the option’s intrinsic value.

An option should never be worth less than its intrinsic value. If an option was ever being sold for less than its intrinsic value, experienced traders would buy the option and exercise it immediately (for the intrinsic value). The profit they would make would be equal to the difference between how much they paid for the option and the amount they get for exercising it (less commission fees).

Remember, options (specifically American options) can be exercised at any time before they expire. Options are always worth a minimum of their intrinsic value because they can be exercised for their intrinsic value at any time.

Extrinsic Value Example –

Assume a trader buys a put option on XYZ stock. The stock is trading at $50, and the trader buys a put option with a strike price of $45 for $3. It expires in five months.

At the time of purchase, that option has no intrinsic value because the stock price is above the strike price of the put option. Assuming implied volatility and the price of the stock stay the same, as the expiration date approaches the option premium will move toward $0.

If the stock falls below the put strike price of $45, then the option will have intrinsic value. For example, if the stock falls to $40, the option has $5 in intrinsic value. If there is still time until the option expires, that option may trade for $5.50, $6, or more, because there is still extrinsic value as well.

Intrinsic value does not mean profit. If the stock drops to $40 and the option expires, the option is worth $5 because of its intrinsic value. The trader paid $3 for the option, so the profit is $2 per share, not $5.

 

Information Sources:

  1. squarespace.com
  2. investopedia.com