Extrinsic value reflects the difference between an option’s purchase price, premium, and its inherent value. It refers to the part of an option’s value that is determined by variables other than the underlying asset’s valuation.
Extrinsic value is the complete opposite of intrinsic value, which refers to an option’s inherent worth. It increases as the volatility within the stock market continues to rise. The cost and set premiums for options are based on inherent values.
Extrinsic Value Example
For example, let’s say a trader purchases a put option for ABC stock that is trading at $55. The put option was initially purchased by the option trader with a strike price of $50 for $5. Additionally, this option is set to expire in the next 7 months. It has no intrinsic value because the strike price is less than the price of the stock price.
Additionally, it is important to note that intrinsic value is different from extrinsic. This is because intrinsic value is the measure of what an underlying asset is actually worth. As the option moves close to its expiration date the set premium will eventually have no value. This is based on if the price were to not change and its implied volatility did not fluctuate.
The extrinsic value is a representation of any external factors that can potentially affect the option’s intrinsic value. It essentially shows the excess value for an option.
How Is Extrinsic Value Calculated?
How to calculate the extrinsic value is fairly simple. Essentially, you have to take the option’s premium (also known as its market price) and subtract it from its intrinsic value.
Factors That Affect Extrinsic Value
Time Left to Expiration
Expiration dates for options or derivatives are valid up until their set expiration date. As the time left for an option continues to decrease, it will eventually be left with its intrinsic value. As time passes the value will fully decay. Meaning, there will be no time left for the price to go In-The-Money, or Out-The-Money. Out-The-Money options solely have extrinsic value and In-The-Money options have intrinsic value.
Options that have longer contracts will have more extrinsic value. Owners of options could choose to exercise an option in order to potentially make a net profit or a net loss. On the contrary, they can let the option contract expire leaving it void and useless.
The expiration date of a derivative depends on the type of derivative being traded. The longer it takes for a stock to hit its strike price, the more the derivative will be worth.
Underlying Stock Volatility
Extrinsic value will increase with a high amount of volatility in the stock market. Volatility is the price movement that exists outside of the trend on the stock market. This value tells investors the expected price movements that the market is expecting that exist outside of the trend.
If the underlying stock volatility increases that causes the options extrinsic value to also start to rise. The total value of an option is equal to the current value plus the time and volatility value. The extrinsic value is a representation of any external factors that can potentially affect the intrinsic value of the option. It is the excess value that is often referred to as the risk premium for an option.
Underlying Stock Dividends
Dividends for a stock will affect how different options are priced. Holders of underlying shares of a stock are able to receive dividends. However, call and put holders do not receive any stock dividends, which is why underlying dividends can impact the set pricing of options.
Call options will decrease in value when the underlying stock goes dividend. This is because the price of an option is a direct reflection of the dividends that have to be paid.
Difference Between Intrinsic And Extrinsic Value?
Intrinsic value is a term used to describe an asset’s actual or perceived value. It represents the worth of an asset and is based on the process of determining a company’s underlying value.
Intrinsic value is important because it can be utilized by investors to determine the stock’s actual value. They compare the intrinsic value to the current stock price to determine whether the stock is being over or undervalued. Financial analysts use the discounted cash flow model, residual income, or an asset based valuation to find the intrinsic value.
However, extrinsic value is the opposite of intrinsic. It refers to the part of an option’s value that is determined by variables other than the underlying asset’s valuation.
Getting Help to Understand Extrinsic Value
Extrinsic value reflects the difference between an option’s purchase price, premium, and its inherent value. It is any excess value of an option, which will increase with a high amount of volatility in the stock market.
Financial advisors can help you with option trading and help improve your family’s financial situation. They can provide you with the knowledge you need to plan out your finances and work towards achieving your goals. You should contact a financial advisor to help you manage your money and make well-informed investment decisions.