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.

Example

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.

RELATED TERMS
  1. Option Premium

    1. The income received by an investor who sells or "writes" an ...
  2. Time Value

    The portion of an option's premium that is attributable to the ...
  3. At The Money

    A situation where an option's strike price is identical to the ...
  4. Put Option

    A put options is an option contract giving the owner the right, ...
  5. Implied Volatility - IV

    The estimated volatility of a security's price derived from an ...
  6. Deep In The Money

    A deep in the money option has a strike price significantly below ...
Related Articles
  1. Trading

    The Basics Of Option Price

    Learn how options are priced, what causes changes in the price, and pitfalls to avoid when trading options.
  2. Trading

    Understanding Option Pricing

    This article will explore what factors you need to consider in the pricing of options when trying to take advantage of a stock price's movement.
  3. Trading

    What Is Option Moneyness?

    Get the basics under your cap before you get into the game.
  4. Trading

    Avoid These 10 Mistakes When Trading in Cheap Options

    Cheap options can be very risky. Reduce your risk by avoiding these 10 common mistakes in trading in cheap options.
  5. Trading

    The importance of time value in options trading

    Move beyond simply buying calls and puts, and learn how to turn time-value decay into potential profits.
  6. Investing

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value can be subjective and difficult to estimate. It’s a perception of a security’s value that factors tangible and intangible factors.
  7. Trading

    Implied Volatility: Buy Low and Sell High

    The success of an options trade can be significantly enhanced by being on the right side of implied volatility changes.
RELATED FAQS
  1. What happens when a security reaches its strike price?

    Learn more about the moneyness of stock options and what happens when the underlying security's price reaches the option ... Read Answer >>
  2. When is a call option considered to be "in the money"?

    Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>
  3. Do you always have to consider intrinsic value when purchasing a stock? Why or why ...

    Take a deeper look at why value investors consider a stock's intrinsic value an important consideration before picking a ... Read Answer >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
Hot Definitions
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  3. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  4. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  5. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center