Education Lesson 15
Extrinsic Value
What is Extrinsic Value?
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. Basics of Extrinsic Value Extrinsic value, and intrinsic value, comprise 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.
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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.