The Time, Intrinsic, and Extrinsic Value of Money Invested in Options

Let’s talk pricing.

Options are priced based on their intrinsic and extrinsic value. Intrinsic value comes from comparing the raw strike and stock prices, and extrinsic value accounts for all of the surrounding variables such as volatility and time value of money.

A broker crunches these numbers together and comes up with the premium.

Traders can also run numbers to hedge their bets.

Intrinsic value

Intrinsic value is the difference between an option’s strike price (the price at which the holder can exercise his option) and the current price of the underlying stock.

A call option has intrinsic value when its strike price is lower than the stock price.

With a call option, when the strike price is below the stock price the holder can buy the stock for less than it’s currently worth. With a put option, when the stock price is below the strike price the holder can sell the stock for more than it’s currently worth.

In both cases, intrinsic value is the difference between prices. If the option is out of the money, the intrinsic value is zero.

Why trade stock options at all? Here are a few roles they can play in your portfolio.

Extrinsic value

Extrinsic value accounts for all of the third party variables, including time.

Where intrinsic value is what the option would pay at the time of purchase, extrinsic value accounts for everything that can happen between sale and execution.

This is where judgment comes in between two traders.

An option seller will price extrinsic value based on how much value he thinks the contract can lose. For a call option, how high does he expect the stock price to rise before the expiration date? For a put option, how low does he expect the stock price to dip?

Part of this is time value. The more time between the sale and the expiration date, the more unpredictable a stock price gets. In general, then, time adds to the extrinsic value of a contract.

Pricing

Intrinsic value sets the floor for the price of an option.

As the set value at the time of contract if the intrinsic value were higher than the premium traders would immediately exercise their options to grab up the guaranteed profit. As a result, an option premium is priced as a combination:

Premium = intrinsic value + extrinsic value, and Extrinsic value = time value + everything else.

Stocks vs. stock options can be confusing. Here’s some clarity!

Examples

1. Put option with a strike price of $15 and a premium of $7. GameCo’s stock is at $10.Intrinsic value: $15 (strike) – $10 (stock) = $5

If we execute the contract immediately, we could sell each share of GameCo for $5 more than it’s worth.

Extrinsic value: $7 (premium) – $5 (intrinsic) = $2

The seller believes that GameCo won’t add more than $2 to its intrinsic value (it won’t go above $12 per share).

2. A call option with a strike price of $15 and a premium of $7. GameCo is selling for $20.Intrinsic value: $20 (stock) – $15 (strike) = $5

If we execute the contract immediately, we could buy each share of GameCo for $5 less than it’s worth.

Extrinsic value: $7 (premium) – $5 (intrinsic) = $2

The seller believes that GameCo won’t decline to less than $18, which would add $2 to its intrinsic value.

3. Out of the money. GameCo is selling for $10. We sell a put option with a strike price of $5 and a premium of $1.

Intrinsic value: $5 (strike) – $10 (stock) = 0

The contract is currently worthless.

Extrinsic value: $1 (premium) – $0 (intrinsic) = $1

The seller believes GameCo might actually go as high as $11 over the time of the contract, but no higher.