A Guide to Extrinsic Value in Options Trading
In options trading, intrinsic value and extrinsic value are key components. Extrinsic value directly impacts the pricing and potential profitability of options and different factors affect it. Understanding them is vital for traders when they are developing options strategies that hinge on future market movements.
Read on to learn more.
What is extrinsic value?
Extrinsic value of option, also known as time value, is the portion of an option's price that exceeds its intrinsic value. It reflects the additional premium that traders are willing to pay due to factors such as time to expiration, volatility, dividends, and interest rates. The concept of extrinsic value is important in options trading because it accounts for the potential of an option to increase in value due to future changes in the price of the underlying asset.
How extrinsic value works
Several factors contribute to how extrinsic value works:
Time to expiration: The more time an option has until expiration, the higher its extrinsic value tends to be, as there's a greater probability that the option could move into a profitable position before it expires.
Volatility: Higher volatility increases the likelihood that the option will move into a profitable position, leading to higher extrinsic value while lower volatility decreases extrinsic value because there is less potential for significant price movements.
Interest rates: Higher interest rates generally increase the extrinsic value of call options and decrease the extrinsic value of put options.
Market conditions: During periods of uncertainty or high market volatility, options may have higher extrinsic value as traders are willing to pay more for the potential profits they offer.
How to calculate extrinsic value
Extrinsic value definition is calculated by subtracting the intrinsic value from the total value (or market price) of the option. For an extrinsic value example, an option with an intrinsic value of $2, currently trading for $6, has a $4 extrinsic value.
It's important to note that extrinsic value decreases as it approaches its expiration date. Extrinsic value can increase with higher implied volatility as it suggests a greater potential for the underlying asset price to change, increasing the option's potential future value.
Extrinsic value example
A stock is trading at $100 per share. An investor purchases a call option with a strike price of $105 with a $5 premium. It expires in one month. Initially, the option has no intrinsic value because the market price of $100 is below the $105 strike price.
After two weeks, the stock price remains at $100, with two weeks remaining until expiration. At this point, the option still has no intrinsic value and the extrinsic value of the option might have decreased to $3, which reflects the diminishing probability that the stock price will rise above $105 within the remaining time frame.
What affects extrinsic value in options trading?
Besides time until expiration, implied volatility and interest rates, other factors affect extrinsic value:
Dividend payouts: For call options, the anticipation of dividends tends to decrease extrinsic value, as holding the asset becomes less attractive due to the impending payout. For put options, expected dividends can increase extrinsic value, as they make holding the option relatively more appealing.
Underlying asset price movement: The closer the price of the underlying asset is to the option's strike price, the higher the extrinsic value as the probability of the option expiring in-the-money increases, making it more valuable.
Market demand and supply: High demand for a specific option can drive up its premium, increasing the extrinsic portion of the price. Similarly, an oversupply can lead to reducing extrinsic value.
Extrinsic values for call and put options
Call options
For call options, if the stock price is above the strike price, the extrinsic value is equal to the option price minus the difference between the stock price and the strike price. If the stock price is below the strike price, the extrinsic value is equal to the option price.
Here's an example. A stock is trading at $110, and a call option has a $100 strike price at $15. The intrinsic value of this call option is $10 (the difference between the stock's current market price minus its strike price) and the extrinsic value of the call option is $5 (the total price of the option minus its intrinsic value).
Put options
For put options, if the underlying security's price is trading above the strike price, the option's premium is only comprised of its extrinsic value. And if the stock price is below the strike price, the extrinsic value is equal to the option price minus the difference between the strike price and stock price. Otherwise, the extrinsic value is equal to the option price.
Here's an example. A stock is trading at $50, and a put option has a $55 strike price at $7. The intrinsic value of this put option is $5 (since the strike price is higher than the stock price) and the extrinsic value of the put option is $2 (the total price of the option minus its intrinsic value).
Potential pros and cons of extrinsic value
Potential pros
Potential for higher returns: Offers traders the chance to profit from price movements of the underlying asset without the need for the asset to reach a specific price point immediately.
Flexibility and opportunity: Options with significant extrinsic value typically have more time until expiration, offering a greater timeframe for the underlying asset's price to move favorably.
Leverage: By investing in options rather than the underlying asset directly, traders can manage relatively larger positions with a smaller initial capital outlay as it can amplify potential returns from favorable movements in the underlying asset’s price. However, this (leverage) can also amplify potential losses.
Potential cons
Time decay (theta): As the option approaches its expiration date, the extrinsic value diminishes and results in a loss of value over time if the underlying asset does not move significantly in the trader's favor.
Volatility impact: While high volatility can benefit extrinsic value, it can also make options pricing highly unpredictable. Sudden drops in volatility can erode the extrinsic value rapidly.
Complexity in valuation: Calculating extrinsic value can be complex, requiring consideration of several factors, potentially making it difficult for less experienced traders to accurately assess the 'value' of an option.
Risk of overpaying: Traders might overpay for options with high extrinsic value, especially if they misjudge the likelihood of favorable price movements in the underlying asset. This overvaluation can result in financial losses if the asset's price does not move as expected within the option's timeframe.
Intrinsic vs extrinsic value: What's the difference
While intrinsic value and extrinsic value are two components of an option's total value, they represent different concepts. Intrinsic value is based on the current relationship between the option's strike price and the market price of the underlying asset, while extrinsic value is based on factors such as time, volatility, dividends, and interest rates. Together, intrinsic value and extrinsic value make up the total value of an option.
FAQs about extrinsic value
What are the options with the highest extrinsic value?
At-the-money options (or close to it) have the most extrinsic value because there's more uncertainty about whether they'll end up being profitable. Options with longer expiration dates have higher extrinsic values than options with shorter expiration dates as there's a greater chance for the underlying asset's price to change. And options on assets with higher implied volatility will have higher extrinsic values.
What factors impact an option’s extrinsic value?
The extrinsic value of an option (time value) is influenced by different factors:
Contract length: The longer the time an option has until expiration, the higher its extrinsic value will be. As expiration approaches, extrinsic value decreases and ultimately goes to zero as it expires.
Implied volatility: Measures the amount an underlying asset may move over a specified period. If an underlying asset's volatility increases, the extrinsic value will also increase and vice-versa.
Interest rates: Higher interest rates can increase the cost of carrying the underlying asset and it can increase a call option's extrinsic value.
Dividend yield: If the underlying asset pays a dividend, it can affect the extrinsic value.
Can an option have negative extrinsic value?
Under normal circumstances, extrinsic value cannot be negative.