Extrinsic Value
Extrinsic value (also called time value) is the portion of an option’s premium that exceeds its intrinsic value. It reflects factors other than the option’s immediate in‑the‑money amount—primarily time until expiration and implied volatility.
How extrinsic and intrinsic values combine
An option’s premium = intrinsic value + extrinsic value.
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- Intrinsic value is the immediate, in‑the‑money amount: for a call, max(0, underlying price − strike); for a put, max(0, strike − underlying price).
- Extrinsic value is the remainder of the premium after subtracting intrinsic value. It represents the market’s assessment of the chance the option will become more valuable before expiration.
Example:
– Call option with strike $20, underlying at $22 → intrinsic = $2.
– If the option trades for $2.50, extrinsic = $0.50.
Key influences on extrinsic value
- Time to expiration (theta/time decay): More time means more extrinsic value because there is greater chance the underlying will move favorably. Extrinsic value typically declines as expiration approaches and is zero at expiration.
- Implied volatility (vega): Higher implied volatility increases the likelihood of large price moves and therefore raises extrinsic value; lower implied volatility reduces it.
- Moneyness: Out‑of‑the‑money options consist entirely of extrinsic value; in‑the‑money options include both components.
Example scenario
A trader buys a put on XYZ:
– Underlying price: $50
– Put strike: $45
– Premium paid: $3
– Time to expiration: 5 months
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At purchase, the put has no intrinsic value (50 > 45), so the entire $3 is extrinsic value. If, before expiration, the stock falls to $40:
– Intrinsic value = $5 (45 − 40).
– If time and volatility remain, the option might trade above $5 (for example, $5.50) because of remaining extrinsic value.
– Profit on exercise/expiration is intrinsic minus premium paid: $5 − $3 = $2 per share (intrinsic value is not the same as profit until you account for cost).
Practical notes
- Extrinsic value decays over time and typically accelerates as expiration nears.
- Traders who sell options often aim to benefit from time decay; buyers generally pay extrinsic value betting on favorable moves or volatility increases.
- Monitoring implied volatility and time remaining is essential when evaluating or trading options.
Key takeaways
- Extrinsic value = option premium − intrinsic value; also called time value.
- Time to expiration and implied volatility are the primary drivers.
- Out‑of‑the‑money options are entirely extrinsic value; extrinsic value falls to zero at expiration.