Intrinsic and extrinsic value

An option's price has two parts. One part you could collect right now by exercising. The other part is what the market is charging for the possibility that things get better before expiration. Separating the two is the first pricing skill, and it takes thirty seconds per option once you have the habit.

Intrinsic value

Intrinsic value is what the option would be worth if it expired this instant.

• Call intrinsic = max(stock − strike, 0)
• Put intrinsic = max(strike − stock, 0)

It can never be negative. An option with positive intrinsic value is in the money (ITM); one with zero intrinsic value is out of the money (OTM); one whose strike equals the stock price is at the money (ATM).

Extrinsic value

Extrinsic value (also called time value) is everything else:

extrinsic = option price − intrinsic

It is what you pay for time and uncertainty. It is always zero or positive while the option is alive, and it is exactly zero at expiration. Every long option position is, in part, a purchase of extrinsic value that will go to zero; every short option is a sale of it.

A chain, decomposed

XYZ at $50.00, 30 days to expiration.

Three things to notice.

First, extrinsic value peaks at the money and shrinks in both directions. The $50 call carries $1.90 of pure time value; the $44 call, deep in the money, carries only $0.40 even though it costs three times as much. That is because the deep ITM call is nearly certain to finish in the money, so there is little "possibility" left to price.

Second, the OTM options are all extrinsic. The $56 call at $0.25 has no intrinsic value at all; every cent of it will vanish unless XYZ moves above $56.

Third, for the same distance from the money, calls and puts carry similar extrinsic value. The small differences come from interest rates and dividends, which the put-call parity lesson explains.

Why extrinsic value exists

Suppose the $50 call had no extrinsic value and traded at exactly $0.00 with XYZ at $50. You would buy as many as you could, because you would have a free right to buy XYZ at $50 for 30 days: if XYZ rose, you win, and if it fell, you lose nothing. Sellers will not give that away, so the price rises until the expected value of that asymmetric payoff is paid for. The more time until expiration and the more the stock tends to move, the more that asymmetry is worth. Time and volatility are the two inputs that set extrinsic value; Modules 3 and 4 take them one at a time.

Key idea: Price = intrinsic + extrinsic. Intrinsic is what the option is worth today; extrinsic is what you pay for the chance of more, and it always reaches zero at expiration.

A worked P&L in both parts

You buy the $53 call at $0.75 with XYZ at $50. Two weeks later XYZ is $53.50 and the call trades at $1.60.

• Intrinsic now: $53.50 − $53 = $0.50.
• Extrinsic now: $1.60 − $0.50 = $1.10.
• Your gain: $1.60 − $0.75 = $0.85 per share, $85 per contract.

Notice that most of your option's value is still extrinsic. If XYZ sits at $53.50 for the remaining two weeks, the extrinsic $1.10 will decay to zero and you will be left with $0.50 intrinsic, a loss of $0.25 from your entry even though the stock went up $3.50. This is the mechanism behind the "right direction, still lost" trades in Module 5.

Parity: an in-the-money option with no extrinsic value

Occasionally a deep ITM option trades at or even slightly below intrinsic value. That is called trading at parity and it usually signals a wide bid-ask, an approaching dividend, or simply nobody bidding. Deep ITM options behave almost exactly like stock, and Module 7 explains why a short deep ITM call with near-zero extrinsic value is a candidate for early assignment.

Try it: Pull up a chain for a stock you follow. For five strikes around the current price, compute intrinsic and extrinsic for both the call and the put. Confirm that extrinsic peaks at the money and that the OTM options are entirely extrinsic. Then note how much extrinsic value you would be buying with any trade you were considering.

Recap

• Intrinsic value is max(stock − strike, 0) for calls and max(strike − stock, 0) for puts; it cannot be negative.
• Extrinsic value is price minus intrinsic; it is the cost of time and uncertainty and is zero at expiration.
• Extrinsic value is largest at the money and shrinks as an option moves deeper in or out of the money.
• OTM options are 100% extrinsic; they are worth nothing unless the stock moves through the strike.
• A trade can be right on direction and still lose if the extrinsic value paid decays faster than intrinsic value builds.