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INTRINSIC AND EXTRINSIC VALUE

By ProbabilityofProfit.com

Intrinsic value reflects the current tangible worth of an option, based on the difference between the underlying asset's price and the option's strike price. Extrinsic value includes factors such as time remaining until expiration, volatility, and interest rates, which contribute to the option's potential future price. Investors often use these values to make informed decisions regarding option trading strategies.
This guide will explore the distinctions between intrinsic and extrinsic value, delve into the factors shaping extrinsic value, discuss trading implications and strategies, analyze time decay and expiration dates, and examine the practical applications within dynamic market conditions.

FUNDAMENTALS OF INTRINSIC AND EXTRINSIC VALUE

INTRINSIC VALUE

Intrinsic Value is the actual value of the option if it were to be exercised immediately.
  • Intrinsic value can never be negative, as it is determined by the difference between the current stock price and the strike price. It can vary for both call and put options as seen below:
    • Call Option Intrinsic Value: calculated as current stock price - strike price.
    • Put Option Intrinsic: calculated as strike price - current stock price.

EXTRINSIC VALUE

Extrinsic Value represents the additional value attributed to factors such as time, volatility, and interest rates.
  • Reflects the potential for the option to gain value prior to expiration.
  • Extrinsic value can fluctuate based on market conditions.
    • Higher during periods with more time for potential favorable movements in the underlying asset.

THE BONSAI TREE ANALOGY

A way I like to remember the difference between the two is to use the Bonsai Tree Analogy. In this analogy, the Intrinsic Value of the bonsai tree represents the current, tangible qualities that can be immediately appreciated, while the Extrinsic Value represents the future potential and the additional benefits that may come with time, care, and growth. It can be broken down into two parts:
  • Bonsai Tree Extrinsic Value Analogy: The extrinsic value of a bonsai tree includes its potential for future growth, development, and appreciation. This might encompass factors like:
    • The potential for the tree to become more valuable as it ages.
    • The possibility of further refinement and improvement in its shape and structure.
    • The anticipation of future enjoyment and the tree's role in creating a tranquil and aesthetically pleasing environment.
    • The prestige and satisfaction derived from owning a well-maintained bonsai. 
       
  • Bonsai Tree Intrinsic Value Analogy: The intrinsic value of a bonsai tree can be seen as its immediate aesthetic appeal and craftsmanship. This includes the tree's shape, health, age, and how well it has been maintained and pruned. Just like the intrinsic value of an option is the immediate, tangible worth, the intrinsic value of a bonsai is the immediate visual and artistic pleasure it provides.

INTRINSIC VALUE AND ITM/OTM OPTIONS

Moneyness: describes the relative position of the underlying asset's current price to the strike price of an option. It indicates whether exercising the option would be profitable or not, and it is classified into three main categories:
  • In-The-Money (ITM): have intrinsic value because they have immediate value if exercised.
  • Out-The-Money (OTM): have no intrinsic value and only extrinsic value.
  • At-The-Money (ATM): have no intrinsic value but do have extrinsic value. on market conditions.
 Intrinsic value generally makes in-the-money options more expensive than at-the-money or out-of-the-money options.
  •  ITM options already possess immediate exercise value.

FACTORS INFLUENCING EXTRINSIC VALUE

CONTRIBUTING FACTORS

  1. Time until expiration
    • Increased time until expiration increases extrinsic value.
    • Provides a longer period for the underlying asset to move in a favorable direction.
  2. Implied volatility
    • Higher volatility increases extrinsic value.
    • Raises the probability of significant price movements that can make the option more profitable.
  3. Interest rates
    • Higher interest rates tend to decrease extrinsic value.
    • The increased cost of carrying the underlying asset with higher interest rates decreases the extrinsic value.

THE VOLATILITY IMPACT

  • Higher Volatility generally leads to increased extrinsic value because there is a higher likelihood of the underlying asset reaching profitable levels for option holders.
    • This makes the option more attractive as the potential for gain increases.
  • Lower Volatility tends to reduce extrinsic value as there is less uncertainty and potential for significant price movements.
    • This makes the option less valuable as the potential for gain decreases.

INTEREST RATE CHANGE

  • Higher Interest Rate increase the cost to carry and reduces extrinsic value.
    • This makes the option more expensive to hold.
  • Lower Interest Rate increases extrinsic value and decreases the cost to carry.
    • This makes the option more attractive.

TRADING DECISIONS AND STRATEGY

NEGATIVE EXTRINSIC VALUE INDICATIONS

Negative Extrinsic Value is possible especially for options nearing expiration or when volatility decreases significantly.
  • Implies that the option is not worth exercising and is primarily composed of the time value component.
    • Offers limited profitability.

DECISION MAKING

Investors may use intrinsic value to determine whether an option is currently profitable to exercise.
  • In-the-money options with significant intrinsic value might be exercised or sold for immediate profit. 
Helps investors assess the premium they are paying for the potential movement of the underlying asset and the time remaining until expiration.
  •  Investors might opt to hold options with high extrinsic value, betting on favorable price movements or time decay to enhance profitability.

TIME DECAY AND EXPIRATION DATE

OTM OPTIONS EXTRINSIC VALUE

Out-of-the-money options have no intrinsic value because the current price of the underlying asset is not favorable for immediate exercise.
  • However, they can still possess extrinsic value due to the possibility of the underlying asset moving in a favorable direction before expiration.

TIME DECAY AND EXTRINSIC VALUE

Time decay (Theta Decay) reduces the extrinsic value of options as expiration approaches.
  • The closer an option gets to expiration, the faster its extrinsic value diminishes, especially for out-of-the-money options.

EXPIRATION AND EXTRINSIC VALUE

Longer Expiration Dates have more time for the underlying asset to move in a favorable direction, leading to higher extrinsic value. 
  • Additionally, longer expiration periods reduce the impact of time decay & provide more extrinsic value over time.

EXAMPLES

CALL OPTION EXAMPLE

Scenario: An investor purchases a call option with a strike price of $100 for a premium of $25, anticipating a potential profit if the stock, currently trading at $120, exceeds the strike price before the option expires in 3 months. 

 

Intrinsic Value Calculation:
  • Intrinsic Value: Current stock price - Strike price
  • Calculation: $120 - $100 = $20
  • Explanation: The intrinsic value is $20 because if the call option is exercised now, the buyer can buy the stock at $100 and immediately sell it at $120, realizing a $20 profit per share.

 

Extrinsic Value Calculation:
  • Extrinsic Value: Option price (Premium) - Intrinsic value
  • Calculation: $25 - $20 = $5
  • Explanation: The extrinsic value is $5, representing the additional value attributed to the time remaining until expiration, potential future price movements, and market conditions.

PUT OPTION EXAMPLE

Scenario: An investor purchases a put option with a strike price of $90 for a premium of $18, anticipating a potential profit if the stock ,currently trading at $80, falls further below the strike price before the option expires in 3 months.

 

Intrinsic Value Calculation:
  • Intrinsic Value: Strike price - Current stock price
  • Calculation: $90 - $80 = $10
  • Explanation: The intrinsic value is $10 because if the put option is exercised now, the buyer can buy the stock at $90, while it is currently worth $80, realizing a $10 profit per share.

 

Extrinsic Value Calculation:
  • Extrinsic Value: Option price (Premium) - Intrinsic value
  • Calculation:  $18 - $10 = $8
  • Explanation: The extrinsic value is $8, representing the additional value attributed to the time remaining until expiration, potential future price movements, and market conditions.

BUYING VS SELLING IMPLICATIONS

The Buyer and Seller Perspective: the intrinsic and extrinsic values themselves do not change based on whether you are buying or selling the call or put option; they are inherent properties of the option itself. However, the perspective and financial implications differ as seen from our call and put example above:

 

Buying the Call Option:
  • Implication: The buyer expects the stock price to continue rising. The intrinsic value provides immediate profit if exercised, while the extrinsic value represents the additional cost paid for the potential of future price movements and time until expiration.
  • Intrinsic Value: $20 (Current stock price $120 - Strike price $100)
  • Extrinsic Value: $5 (Option price $25 - Intrinsic value $20)

 

Selling the Call Option:
  • Implication: The seller expects the stock price to stay below the strike price or to increase only slightly. The intrinsic value represents the immediate loss if exercised by the buyer, while the extrinsic value is the premium received as compensation for taking on the risk of the stock price increasing.
  • Intrinsic Value: $20 (Immediate potential loss if exercised by the buyer)
  • Extrinsic Value: $5 (Premium received for taking on the risk)
 
Buying the Put Option:
  • Implication: The buyer expects the stock price to decrease. The intrinsic value provides immediate profit if exercised, while the extrinsic value represents the additional cost paid for the potential of future price movements and time until expiration.
  • Intrinsic Value: $10 (Strike price $90 - Current stock price $80)
  • Extrinsic Value: $8 (Option price $18 - Intrinsic value $10)
     
Selling the Put Option:
  • Implication: The seller expects the stock price to stay above the strike price or to decrease only slightly. The intrinsic value represents the immediate loss if exercised by the buyer, while the extrinsic value is the premium received as compensation for taking on the risk of the stock price decreasing.
  • Intrinsic Value: $10 (Immediate potential loss if exercised by the buyer)
  • Extrinsic Value: $8 (Premium received for taking on the risk) 
 
Key Difference: In both buying and selling scenarios, the intrinsic and extrinsic values remain the same, but their implications differ based on the perspective of the buyer or seller.

CONCLUSION

Understanding the nuances of intrinsic and extrinsic values is key to mastering the art of option trading. These values are fundamental to knowing which side of the trade to take as buyers chase potential profits from favorable price swings, while sellers look to pocket premiums and handle the risks. By appreciating these differences and their influence on trading strategies, you can make smarter and more intuitive decisions when trading. Thanks for diving into this guide with us. We trust it has shed some light on the intricate world of option value.

REFERENCES

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