In Option Basics - Part 1 we discussed the Option Contract, Assignment and Exercise, and American and European style options. In Option Basics - Part 2 we discussed the components that comprise an option's price and the Greeks.
In Part 3 we will be discussing Intrinsic and Extrinsic value: two components that comprise and option's overall value. See graphic.
An option has intrinsic value only when it is ITM (in-the-money). This occurs when the underlying's current price exceeds the option's Strike price; that is, for a Call option, the underlying's current price is higher than the option's Strike price, and for a Put option, the current price is below the Strike price.
To calculate the intrinsic value, simply determine the difference between the underlying's price and the option's Strike price. For example, if a Put option has a strike price of $125 and the underlying's current price is $100, then the intrinsic value of the option is $25. If the underlying's current price rises to $130, then the Put option's intrinsic value is zero (it is no longer ITM).
Until expiration, an option will always have some extrinsic value, even when it is deep ITM.
To calculate extrinsic value, simply subtract from the current value of the option its intrinsic value. If the option is OTM, then extrinsic value is the total current value of the option (since intrinsic value is zero).
What determines extrinsic value? Many mistakenly attribute it to time value (or time decay, the option's remaining days left till expiration), but this is just one component. Other factors are: volatility, price of the underlying, dividends, and changes in the risk-free rate of interest (the remaining components that comprise the option's price).
For example, if the difference narrows significantly between the strike price of an OTM option and the underlying's price, the extrinsic value will likely increase (representing the higher probability of expiring ITM), even though there is now less time till expiration. Or, if the implied volatility of the underlying increases significantly, the extrinsic value will increase (again representing the higher probability of expiring ITM) despite the time factor.
A better description of extrinsic value is that it is a measure of risk; that is, it quantifies the value of risk for that option, including days till expiration.
Extrinsic value is greatest ATM (see chart above). As the option moves further OTM or ITM, the extrinsic value declines, representing the declining probability of expiring ITM (for OTM options), or expiring OTM (for ITM options).
In conclusion, the total value of an option is the combination of its intrinsic value and extrinsic value (or risk value).
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.