Intrinsic and Extrinsic Value of Options
One of the most important factors to remember with options is that they expire at some date in the future. Options premium is made up of two types of values: intrinsic and extrinsic. Intrinsic value is what value of the option has real value at expiration and extrinsic value is the extra time premium associated with an option based on how many days are left until it expires. This time value component is determined by the market or what it expects the stock to do in the given time period. The expected move range is calculated by implied volatility and is part of how extrinsic value is determined. But simply put the more time till expiration remaining the higher the extrinsic value will be. The higher that implied volatility is in the stock, then the higher extrinsic value will be as well.
If TSLA is trading at $750 and the one month call option at the $740 strike price is priced at $30, that means the option contract has 10 dollars of intrinsic value. The amount it would be worth if today was the expiration date. If a stock price is ABOVE the call option strike price it has some kind of intrinsic value and is known as being “in-the-money”. But if the stock price of TSLA falls below that 740 strike price, the option has only extrinsic value to it because outside of the time value of the option, it would be worth zero at expiration if below the call option strike price. This is also known as being “out-of-the-money”.
Option premium = $30.00 minus $10.00 (intrinsic value) = $20.00 of Extrinsic value
If TSLA is trading at $750 and the one month call option at the $760 strike price is priced at $20 that means all of its value is extrinsic time value and it is out-of-the-money because the stock price is below the strike price. The market is pricing in a certain probability that it may go higher by the expiration date otherwise it would not still be holding a premium. The option being out-of-the-money makes it cheaper but also with that comes a lower odds of being profitable if purchased. Theoretically, if an options price is made up of solely extrinsic value it needs the stock to move in that direction to increase in value or even offset the daily time decay of the option, or theta. Extrinsic value is also made up of implied volatility or what the market is pricing in as an expected volatility or range within the given time period. A stock with an Implied volatility of 70% is going to have higher priced options and daily volatility than a stock with an IV of just 30%.
In-the-Money and Out-of-the-Money
ITM and OTM stands for whether a stock option is In-the-money or out-of-the-money. This is just an easy way to say whether the option has real intrinsic value or just based only on extrinsic value. ITM options have higher delta’s and generally will move more closely based on the underlying stock movement but an OTM option will have delta’s less than 50 and be more subject to multiple factors controlling its price like implied volatility and time value till expiration. If an option is at-the-money or ATM, that simply means its strike price is right near the current stock price and generally carries a delta near 50. If I buy an ATM call option with a 50 delta, and the stock price rises, you become more long that stock as it rallies since the delta will increase as the option becomes more deep in the money or DITM. Conversely if I am selling a cash secured put that is OTM and the stock rallies, that put becomes less valuable and erodes closer to zero as expiration nears. While this happens the delta decreases as the stock continues higher so the exposure to the stock price movement decreases together. As you can tell the holder of a long option usually benefits most when an option goes ITM while the seller of an option will benefit most when the option stays OTM.
- Options premium is made up of two types of values: intrinsic and extrinsic.
- ITM options represent intrinsic real value and can be exercised
- OTM options only carry extrinsic value based on time until expiration.
- In general if you have long options you want them to go in-the-money (ITM) and if short options you prefer to have them stay out-of-the-money (OTM) and expire worthless.