Understanding Intrinsic and Extrinsic Values
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Option Basics | ITM | OTM
Understanding Intrinsic and Extrinsic Value
Learn about Intrinsic and Extrinsic Value
- Call option intrinsic value = Stock price – Exercise price
- Call option Time Value = Call option price – Intrinsic Value
- The minimum value of intrinsic value is 0.
Trading Volatility
- Volatility will increase all option prices
- Put options are particularly aided by increased volatility
- Call options are hurt by increases in volatility
- ATM options ( 50 delta ) are most sensitive to changes in volatility
- Want to move call options further ITM to avoid sensitivity in volatility AND gain more deltas
If we moved a little further in the money to the 65 delta option, we would avoid the heavier extrinsic value loss AND we would ADD some delta or mimicking power (15 more deltas or about 30%) into the equation.
When we are engaged in short term directional trading or swing trading, it is best to use 50 delta puts for trading downside opportunities and 65 delta calls for trading upside opportunities.
Intrinsic value is the cash you would have if you exercised the call option and then immediately sold the stock at its current price. When you look at an option price, the portion of the premium that is in the money is its intrinsic value.
In other words, it’s how much the option is worth. It is also the portion of the option that won’t lose value because of the passage of time. In fact, intrinsic value is immune to the passage of time. It’s easy to calculate intrinsic value.
For example, if Home Depot is currently $71 per share, then the intrinsic value of the $70 call option is $1. It’s simply the difference between the underlying stock price and the strike price.
Here is a formula to help you remember: Stock price − strike price = intrinsic value
$71 $70 $1
To give you another example, if a stock is trading at $33 and the strike price is $30, the intrinsic value of the call is $3. It has an intrinsic value of $3 no matter when it expires.
Therefore, when you hear traders say that their options have intrinsic value, it simply means their options are in the money (i.e., they are worth something tangible).
Fact: An option that is in the money will be worth at least its intrinsic value. At-the-money and out-of-the-money options have no intrinsic value. They only have time value
<Insert time value decay chart>
The table shown below is a snapshot of call options in ascending strike prices(option series) for a particular stock. The price of the stock is trading at $42.5.
Call option Last($) Intrinsic value Intrinsic Value as a % of option price Time Value Time Value as a % of option price
Jan 12.5 $30.50 $30 98.3% $0.50 1.7%
Jan 15 $28.10 27.5 97.8% $0.60 2.2%
…
Jan 40 $6.25 $2.50 60% $3.75 40%
Let us examine the Jan 12.5 call option. The price of the underlying security is $42.50. Hence, the intrinsic value of Jan 12.5 call is $42.5 – $12.5 = $30 . The time value is thus the option price less the intrinsic value. $30.50 – $30 = $0.50 . As you can see, the time value only makes up approximately 1.7% of the total option premium of $30.50. This is an example where deep ITM options have very little to no time value.
If we move higher up in terms of strike price, you will start to see a trend where the time value as a percentage of the option price becomes larger. Let us examine the Jan 40 call. The intrinsic value is $2.50 while the time value is $3.75. Here, time value makes up a large portion of the option price of $6.25. The conclusion is this: Deep In-The-Money options have little to no time value. The deeper it is in the money, the less time value an option has. Hence, buying deep ITM options is one of the ways to combat the effects of time decay. After all, if there is so little time value left in a deep ITM option, how much time value decay can occur? The answer: Not very much.
Time Value Consideration
Time value decay is always a consideration to make for option buyers. Due to time value decay, the price of an option will decrease over time while keeping other factors constant. There are several ways to mitigate the effects of time value decay.
<Insert time value decay chart>
The table shown below is a snapshot of call options in ascending strike prices(option series) for a particular stock. The price of the stock is trading at $42.5.
Call option Last($) Intrinsic value Intrinsic Value as a % of option price Time Value Time Value as a % of option price
Jan 12.5 $30.50 $30 98.3% $0.50 1.7%
Jan 15 $28.10 27.5 97.8% $0.60 2.2%
…
Jan 40 $6.25 $2.50 60% $3.75 40%
Let us examine the Jan 12.5 call option. The price of the underlying security is $42.50. Hence, the intrinsic value of Jan 12.5 call is $42.5 – $12.5 = $30 . The time value is thus the option price less the intrinsic value. $30.50 – $30 = $0.50 . As you can see, the time value only makes up approximately 1.7% of the total option premium of $30.50. This is an example where deep ITM options have very little to no time value.
If we move higher up in terms of strike price, you will start to see a trend where the time value as a percentage of the option price becomes larger. Let us examine the Jan 40 call. The intrinsic value is $2.50 while the time value is $3.75. Here, time value makes up a large portion of the option price of $6.25. The conclusion is this: Deep In-The-Money options have little to no time value. The deeper it is in the money, the less time value an option has. Hence, buying deep ITM options is one of the ways to combat the effects of time decay. After all, if there is so little time value left in a deep ITM option, how much time value decay can occur? The answer: Not very much.
A long call position will be subject to much time value decay as it approaches expiry. As an example, the trader could sell a higher strike call option to convert the trade into a bull call spread.
While this limits the upside of the long call position, the effect is that time value is mitigated to a certain extent here. While the long position loses on time value decay, the short position gains on time value decay.
Similar adjustments can be made to long put positions by selling a lower strike put option, converting the trade into a bear put spread. Hence, an options trader can always make adjustments to a trade to mitigate time value decay by selling options which are complementary to the existing trade.
Deep in the money call or put options have lots of intrinsic value but little to no time value.
This is a characteristic of options which are deep in the money. For deep in the money options, the intrinsic value as a percentage of the option premium outweighs the time value as a percentage of option premium.
OTM options ands ATM options have no intrinsic value.
The time value makes up the entire option premium. Since time decay occurs at the fastest rate over the last 30 days or so, time value will decrease exponentially over the last 30 days. A trader who holds on to such an option will experience drastic declines in the option premium with all things being equal. Hence, traders should sell off any long ATM or OTM options with less than 30 days to expiration.
Buying a Call
Notes
- Every option contract has a price, and the price consists of two components:
- A formula showing that an option’s price is the sum of its intrinsic and extrinsic value.
- Here’s a quick visualization of an option’s price components:
- Option intrinsic value vs. extrinsic value.
- What are intrinsic and extrinsic value?
- An option’s intrinsic value can be conceptualized as the value of being able to buy or sell shares at the option’s strike price as opposed to the current price of the shares. For example, if a stock is trading for $75, a call option with a strike price of $50 has $25 of intrinsic value. This is because the ability to purchase shares $25 below the market price should be worth at least $25.
- On the other hand, with the stock at $75, a call option with a strike price of $75 has $0 of intrinsic value because exercising the call has no “real” value, as the investor can buy shares for $75 without using an option.
- At expiration, an option’s price will only consist of intrinsic value. Therefore, an alternative definition of intrinsic value is what the option will be worth at expiration (if the stock price were at its current price).
- An option’s extrinsic value is the portion of an option’s price that exceeds its intrinsic value. From the previous example, if the call option with a strike price of $75 is trading for $5, its extrinsic value is $5. This is because the option has no intrinsic value, which means any value it has is extrinsic.
- Why would an option with no intrinsic value be worth anything? Well, there’s a chance that the option ends up being valuable by the time it expires. An option’s extrinsic value is essentially the price associated with the potential for an option to become more valuable before it expires.
- At expiration, options with only extrinsic value will be worthless. So, an option’s intrinsic value will always remain, but the extrinsic value will decrease as expiration approaches, as the option’s real value becomes more certain. For the reasons mentioned here, extrinsic value is often referred to as an option’s “time value.”
- Now that you’ve learned the very basics of an option’s price components, let’s walk through and visualize how they relate to call and put options.
- Intrinsic Value of Call Options
- The intrinsic value of a call option is equal to the value of buying shares at the call’s strike price as opposed to the market price. For example, on a $150 stock, a call option with a strike price of $140 has $10 of intrinsic value because buying shares $10 below the market price should be worth at least $10 per share.
- If the stock price is below the call’s strike price, then the option has no intrinsic value because a call trader has no benefit of buying shares at the strike price, as they can buy shares directly for a lower price. Consequently, any value the option has is extrinsic.
- If the stock is trading above the call’s strike price, the call’s intrinsic value can be calculated with the following formula:
- Formula for calculating a call option’s intrinsic value.
- If the stock price is below the call strike, the intrinsic value is zero. An option will never have negative intrinsic value, so the formula above only applies if the stock price is above the call’s strike price.
- Alright, let’s look at some visual examples of a call’s price components through time. First, we’ll look at an option that has intrinsic value (in-the-money) for most of the time. Then, we’ll finish by looking at a call option that consists of all extrinsic value through expiration.
- In the following visual, we’ll look at the price of a stock (top), and a call option (bottom) with a strike price of $105. Be sure to compare the changes in the option’s intrinsic and extrinsic value as the stock price changes.
- Intrinsic and extrinsic value for an in-the-money call option.
- As you can see, when the stock price is above the strike price of 105, the call has intrinsic value. As the stock price increases further above the strike price, the call’s value shifts from extrinsic value to intrinsic value. Lastly, the call’s extrinsic value withers away as expiration approaches, leaving only intrinsic value in the call’s price at expiration.
- Next, we’ll look at a similar example, except this time with an out-of-the-money call.
- Intrinsic vs. Extrinsic: Out-of-the-Money Call Option
- In this example, we’ll compare a stock’s price to a call option with a strike price of $195. Like before, examine the relationship between changes in the stock price and the call’s intrinsic and extrinsic value.
- Intrinsic and extrinsic value of an out-of-the-money call option.
- As demonstrated here, the stock price traded below the call’s strike price of $195 for almost the entire period. Consequently, the call’s price was purely extrinsic. As expiration approaches, the extrinsic value decreased to $0, leaving the call worthless at expiration.
- In summary, call options have intrinsic value when the stock price is above the strike price. As the stock increases further above the strike price, the call’s price shifts from extrinsic value to intrinsic value. Lastly, any extrinsic value will decay away as expiration approaches.
- Intrinsic Value of Put Options
- The intrinsic value of a put option is equal to the value of selling shares at the put’s strike price as opposed to the market price. For example, on a $50 stock, a put option with a strike price of $55 has $5 of intrinsic value because the ability to sell shares $5 above the current market price should be worth at least $5.
- If the stock price is above the put’s strike price, the option has no intrinsic value. This is because the put owner has no benefit of selling shares of stock at the strike price, as they can sell shares for a higher price in the open market. Consequently, any value the option has consists of extrinsic value.
- If the stock price is below the put’s strike price, the put’s intrinsic value can be calculated with the following formula:
- Formula for calculating a put option’s intrinsic value.
- If the stock price is above the put’s strike price, then the option’s intrinsic value is zero. An option will never have negative intrinsic value, so the formula above only applies when the stock price is below the put’s strike price.
- Alright, let’s look at some visual examples of a put’s intrinsic and extrinsic value in action. First, we’ll look at an option that has intrinsic value (in-the-money) for most of the time. Then, we’ll finish by looking at a put option that consists of all extrinsic value through expiration.
- Intrinsic vs. Extrinsic Value: In-the-Money Put
- In the following visual, we’ll look at the price of a stock (top), and a put option (bottom) with a strike price of $190. Be sure to compare the changes in the put option’s intrinsic and extrinsic value as the stock price changes.
- Intrinsic and extrinsic value of an in-the-money call option.
- As demonstrated here, when the stock price is below the put’s strike price of $190, the put has intrinsic value. As the stock price decreases further below the strike price, the put’s value shifts from extrinsic value to intrinsic value. Lastly, the put’s extrinsic value decays away as expiration approaches, leaving only intrinsic value in the put’s price.
- Next, we’ll look at a similar example, except this time with an out-of-the-money put.
- Intrinsic vs. Extrinsic Value: Out-of-the-Money Put
- In this example, we’ll compare a stock’s price to a put option with a strike price of $80. Like before, examine the relationship between changes in the stock price and the put’s intrinsic and extrinsic value.
- Intrinsic and extrinsic value of an out-of-the-money call option.
- Unfortunately, the put in this example never had any intrinsic value, as the stock price was always above the put’s strike price of $80. Consequently, the put’s price consisted of all extrinsic value. As expiration approached, the extrinsic value decreased to $0, leaving the put worthless at expiration.
- In summary, put options have intrinsic value when the stock price is below the strike price. As the stock decreases further below the strike price, the put’s price shifts from extrinsic value to intrinsic value. Lastly, any extrinsic value will decay away as expiration approaches.
- So, you’ve learned the basics of intrinsic and extrinsic value, and have also seen some specific demonstrations with calls and puts. At this point, you may be wondering what determines how much extrinsic value an option has. Well, you’re in luck, because that is the topic of the next section!
- What Determines an Option’s Extrinsic Value?
- An option’s extrinsic value depends on a few factors:
- 1) Whether the option is in-the-money, at-the-money, or out-of-the-money.
- 2) How much time the option has until it expires.
- 3) The implied volatility of the options
- First, options that are further in-the-money have more intrinsic value and less extrinsic value, and was visually demonstrated in the previous sections. As an option becomes further in-the-money, its value will shift towards intrinsic value.
- At-the-money options will have the most extrinsic value of any option, while out-of-the-money and in-the-money options have less extrinsic value the further the strike price is from the stock price.
- Second, options with more time to expiration are more expensive, and therefore have more extrinsic value than options at the same strike price with less time to expiration.
- In the following visual, we’ll compare four call options on the S&P 500 ETF (SPY) with varying days to expiration (DTE). With the SPY at $216, we’ll look at the 216 call in each respective expiration cycle. Let’s take a look!
- Extrinsic value vs. days to expiration.
- As you can see, longer-term options at the same strike price are more expensive, and therefore have more extrinsic value. This is because there is more time left until the option expires, and therefore more time for the option to increase in value due to stock price changes.
- Lastly, options on higher implied volatility stocks have more extrinsic value. To validate this, let’s look at the 100 calls with 30 days to expiration on three stocks that are trading for $100. Note how the higher option prices indicate higher implied volatility.
- Extrinsic value vs. implied volatility.
- Why is this? Option prices determine implied volatility. When the future movements of a stock’s price are expected to be volatile, market participants are willing to pay more for protection, or to speculate on those movements (in other words, supply/demand leads to higher option prices, and therefore implied volatility).
- All else being equal, if you look at two similarly-priced stocks, the stock with more expensive options will have higher implied volatility.
Option Basics
Tips and Tricks
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )