What is 'Extrinsic Value'
Extrinsic value measures the difference between market price of an option and its intrinsic value. Extrinsic value is also the portion of the worth that has been assigned to an item by external factors. The opposite of an extrinsic value is an intrinsic value, which is the inherent worth of an item.
BREAKING DOWN 'Extrinsic Value'In theory, options should not trade above their intrinsic value due to the time value associated with option pricing.
If a call option has value when the underlying security's price is trading below the strike price, the option's value only stems from extrinsic value. Conversely, if a put option has value when the underlying security's price is trading above the strike price, the option's value is only comprised of its extrinsic value.
Factors Affecting Extrinsic Value
Extrinsic value is also known as time value, because the time left until the option contract expires is one of the primary factors affecting the option premium. Under normal circumstances, a contract loses value as it approaches its expiration date, because there is a lower degree of probability for the option to expire in the month. For example, an option with one month to expiration that is out of the money will have more extrinsic value than that of an out-of-the-money option with one week to expiration.
Another factor that affects extrinsic value is implied volatility. Implied volatility measures the amount an underlying asset may move over a specified period based on market prices. If the implied volatility increases, the extrinsic value will increase. For example, if an investor purchases a call option with an annualized implied volatility of 20% and the implied volatility increases to 30% the following day, the extrinsic value would increase.
For example, an option that has a premium price of $10 and an intrinsic value of $6 would have an extrinsic value of $4. Denoting the amount by which the option's price is greater than the intrinsic value, all else equal, the extrinsic value of the option declines as its expiration date draws closer.
A piece of residential real estate would have intrinsic value based on factors such as its age, condition, square footage and location. The fact that it is the seller's childhood home is part of the home's extrinsic value and does not factor into the price a buyer pays for the home. In this situation, the extrinsic value of the home cannot be conveyed to any buyer except, perhaps, another family member.