Extrinsic Value

In options trading, extrinsic value is widely used to determine the whole price or premium one pays for an option. This comes in contrast with intrinsic value, which only applies when there is a difference between an option’s strike price and a stock’s current price. Extrinsic value, on the other hand, is based on other issues that create the justification or reasoning behind why an option has the price it does. This blog examines what extrinsic value refers to, the work of this value, and the features behind it.  

What is extrinsic value? 

Extrinsic value represents the portion of an option premium above its intrinsic value. It is the premium of an option in addition to the intrinsic value. It reflects the value of an option that exceeds the intrinsic value. This part of an option’s price captures many features that could make it valuable but are not directly related to the underlying price today. Extrinsic value represents the market’s expectations and uncertainties over future movements in the underlying security price.  

Understanding Extrinsic Value 

Understanding extrinsic value naturally is worth doing in comparison with intrinsic value, which is the amount by which an option is in the money. For instance, if it is a call whose strike price is U.S. $45 and the current price of the underlying is US $50, the intrinsic value stands at US$5 (US$50 – US$45). 

On the other hand, extrinsic value depicts everything above this intrinsic value and is influenced by the time remaining to expiration and market volatility. It denotes the potential of the option to become valuable with the variation of the market in its conditions. These are basically the external elements that could make this part of the option premium vary, affecting the overall amount a trader is willing to part with to buy an option. 

Factors Influencing Extrinsic Value

The following factors determine the extrinsic value of an option: 

1.  Time to Expiration: Time to expiration refers to the period left before an option expires. In other words, it is the time value. The longer the time available for an option to expire, the greater the extrinsic value. This is because there is a better chance that the price of the underlying will move favourably. As the date of expiry approaches, the extrinsic value is gradually drained, which is referred to as time decay.
2. Volatility: This is a measure of how much the underlying asset price is expected to fluctuate. Increased volatility increases the extrinsic value because there is an increased possibility that the price of the asset can move in any direction, which, therefore, could make a call option that much more valuable. Decreased volatility leads to decreased extrinsic value.
3. Interest Rates: Changes in interest rates can affect the extrinsic value of options. More or less, as a rule, the extrinsic value in both call and put options will tend to move higher in situations where interest rates rise. The rationale behind this is that the greater the rate at which it is possible to reinvest the cost of holding the underlying asset, the greater the potential value of having the option to purchase at a fixed price. For put options, this result may be exactly the opposite.
4. Dividends: Expected dividends on the underlying can also influence extrinsic value. For call options, an expected dividend can reduce the extrinsic value because the stock price will typically decline by the dividend amount on the ex-dividend date. For put options, the impact can be the reverse: an expected dividend will increase the extrinsic value. 

Components of Extrinsic Value 

Extrinsic value typically consists of two main components: 

1. Time Value: The time value is that part of the extrinsic value that depends upon how far the time to expiry of the option is. The longer the duration, the more chances there will be for asset prices to fluctuate, and so there will be a higher time value.
2. Implied Volatility: This reflects the market forecast incorporating future volatility in the underlying asset’s price. The higher the implied volatility, the larger the extrinsic, as it signals the asset’s price is likely to make larger moves, which maximises the potential option profitability. 

Examples of Extrinsic Value 

1. Call Option with a Long Expiry: Suppose the share in Company ABC is trading at US$100 today, and you purchase a call option for a strike price of US$95, which has a maturity in six months. If your option premium is US$10 and the option intrinsic value is US$5 (US$100 minus US$95), then the extrinsic value would be US$5 (US$10 option premium minus US$5 intrinsic value). High extrinsic value reflects that it runs long towards the expiration of time periods, which gives the option more potential to increase in value.
2. High Volatility Put Option: Consider that the stock of Company XYZ is presently at a market price of US$60. You buy a put option with an exercise or strike price of US$65, paying a total of US$8. If the intrinsic value of the put option price is US$5 (US$65 – US$60), then the extrinsic option’s value is US$3 (US$8 total premium – US$5 intrinsic value). The intrinsic value would be higher if expectations were for increased price volatility.
3. At or Near Expiration Call Option: You can buy Company DEF stock at a strike price of US$120, and the stock is currently selling for US$125. The option has only a week to run. The total premium is US$7, and US$5 of that is intrinsic value (US$125 – US$120). The extrinsic value would be US$2 (US$7 total premium less US$5 intrinsic value). The extrinsic value remaining is low due to the short time before expiration; therefore, there are limited chances for any further price movements. 

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