Extrinsic ValueDefined along with Formula & How to Calculate

Most, if not all, assets have value.

We can often see an asset’s financial value by looking at the asset owner’s financial statements.

For example, you can see an equipment’s value by looking at its owner’s balance sheet.

Some assets, particularly those internally generated (e.g. goodwill), don’t have a value on the balance sheet.

But you just know that they have value – you just can’t put a number on it.

The determination of an option’s value is a bit more complicated than that.

For one, there is the premium or cost of acquiring the option.

However, this cost alone does not determine the value of the option.

We still have to consider its intrinsic value by the time it expires.

An option’s intrinsic value is the difference between its exercise price and the market price of the underlying asset.

For example, a put option’s exercise price is $35 while the market price of its underlying asset is $32.

This means that the put option has an intrinsic value of $3.

An option will only have intrinsic value if it’s trading in the money (ITM).

An out-of-the-money (OTM) option will always have zero intrinsic value.

But just because an option has zero intrinsic value doesn’t mean that it has zero value.

There is still its extrinsic value.

In this article, we will be exploring what extrinsic value is.

What is it? What is its importance in options trading?

And how does one determine an option’s extrinsic value?

We’ll try to answer these questions as we go along with the article.

What is Extrinsic Value?

In broad terms, extrinsic value refers to the value of an asset that is outside of its intrinsic value.

In options trading, extrinsic value measures the difference between an option’s market price (a.k.a. premium) and its intrinsic value.

That is, in other words, an option’s extrinsic value refers to its value that exceeds its intrinsic value.

As such, we can easily compute it by using the following formula:

Extrinsic Value = Market Price of Option (Premium) – Intrinsic Value of Option

For example, let’s say that a put option has an exercise price of  $40, while its underlying asset has a market price of $33.

This means that the option has an intrinsic value of $7 per unit of the underlying asset.

Now let’s say that the option is trading at $8.50. Using the formula above, we get:

Extrinsic Value = Market Price of Option (Premium) – Intrinsic Value of Option

= $8.50 – $7

= $1.50

As per our computation, the option has an extrinsic value of $1.50.

Unlike intrinsic value, an option’s extrinsic value is affected by factors other than the underlying asset’s market price.

This could include time, implied volatility, dividends, interest rates, etc.

The extrinsic value and the intrinsic value comprise the cost or premium of an option.

We can say that the sum of an option’s extrinsic and intrinsic values is its total value.

Now, since an OTM option will always have zero intrinsic value, any value assigned to it will automatically be equal to the option’s extrinsic value.

So if a put option has an exercise price that is lower than the underlying asset’s market price, all of its value will be extrinsic value.

It’s the same case for a call option that has an exercise price that is higher than the underlying asset’s market price.

Factors Affecting Extrinsic Value

There are two main factors that can affect an option’s extrinsic value: the length of the contract, and implied volatility.

However, experienced traders will know that there are more factors other than these two that can affect an option’s extrinsic value.

Length of the Contract

In general, the longer the contract, the higher the option’s extrinsic value.

This is because a longer contract allows the option holder more time for the price of the underlying to move in his/her favor.

For example, the option might be currently trading OTM. However, it is still a year before its expiration.

A lot of things can happen in a year, which allows more opportunity for the price of the underlying asset to move in favor of the option holder.

A contract will generally lose value the closer it approaches its expiration date.

As the option gets closer to its expiration date, there will be less time for the underlying asset’s price to move in favor of the option holder.

All else equal, an option that has a longer contract length will naturally have a higher extrinsic than one that is closer to its expiration date.

Implied Volatility

Implied volatility (a.k.a. vega) measures how much an underlying asset’s market price is expected to move during a set period.

Together with the time value (length of the contract), the implied volatility makes up the extrinsic value of an option.

In general, the higher the implied volatility is, the higher the extrinsic value of an option will be.

The reasoning behind this is that high implied volatility provides a greater chance for the underlying asset’s market price to move in favor of the option holder.

The holder of an OTM option may have more hope of the market price moving to his/her favor because of high implied volatility.

The implied volatility of an underlying asset may also increase or decrease as time goes by.

If it increases, the extrinsic value of the option will also increase.

On the other hand, if it decreases, the extrinsic value of the option will also decrease.

To illustrate, let’s say that the implied volatility of an option’s underlying asset is currently at 25%.

Then the next day, the implied volatility increases to 40%. This results in an increase in the option’s extrinsic value.

Other Factors

Aside from the length of the contract and implied volatility, there are other factors that may affect the premium of an option (which is a determinant of its extrinsic value):

• Time decay – this refers to the rate at which time decreases an option’s value. It is also referred to as theta. Time decay usually works to the benefit of the option seller (a.k.a. the writer)
• Interest rate – changes in interest rates (a.k.a gamma) may impact an option’s value. The effect will depend on the type of option. A high risk-free interest rate generally favors call options. However, changes in interest rates have a negative correlation with put options.
• Dividends – same with interest rates, an underlying stock’s dividend can affect an option’s value. The effect will depend on the type of option. A dividend will decrease the extrinsic value of its call option. On the other hand, it will increase the extrinsic value of its put option.
• Delta – this refers to the sensitivity between the option price and its underlying security. In general, a lower delta will result in a higher extrinsic value.