Extrinsic & Intrinsic Value

Setup to Options Extrinsic & Intrinsic Value

In options trading, there are two types of values that determine the price of an option: intrinsic value and extrinsic value. Let’s dive deeper into what these values mean and how they affect the options market.

Intrinsic Value:

The intrinsic value of an option is the value that it would have if it were exercised immediately. For call options, the intrinsic value is the difference between the current market price of the underlying asset and the strike price of the option.

For example, if the current market price of a stock is Rs. 100 and the strike price of the call option is Rs. 90, then the intrinsic value of the call option is Rs. 10. This is because the option holder could exercise the option, buy the stock at the strike price of Rs. 90, and then immediately sell it at the current market price of Rs. 100 for a profit of Rs. 10 per share.

Similarly, for put options, the intrinsic value is the difference between the strike price and the current market price of the underlying asset.
For example, if the current market price of a stock is Rs. 80 and the strike price of the put option is Rs. 90, then the intrinsic value of the put option is Rs. 10. This is because the option holder could exercise the option, sell the stock at the strike price of Rs. 90, and then immediately buy it back at the current market price of Rs. 80 for a profit of Rs. 10 per share.

Extrinsic Value:

The extrinsic value of an option is also known as the time value. It is the portion of the option premium that is not attributable to the intrinsic value. Extrinsic value is influenced by a number of factors, including the time until expiration, the volatility of the underlying asset, and the level of interest rates.

The extrinsic value of an option is highest when the option is at the money (ATM), meaning the strike price is equal to the current market price of the underlying asset.

This is because, at this point, there is the highest level of uncertainty about the future price of the underlying asset. As the option moves further in the money (ITM) or out of the money (OTM), the extrinsic value decreases.

Examples of Calculations of Intrinsic and Extrinsic Value:

Suppose you are bullish on Reliance Industries Limited (RIL), which is currently trading at Rs. 2,100. You believe that RIL’s stock price will rise in the near future, but you are not sure how much it will increase.

To profit from this potential increase, you can buy a call option on RIL with a strike price of, say, Rs. 2,200, expiring in one month. If the stock price rises above the strike price of Rs. 2,200 before the option expires, you can exercise your option and buy RIL shares at the lower strike price, then sell them at the current market price, making a profit.

The intrinsic value of the option is the difference between the current market price of the stock and the strike price. If the current market price of RIL is Rs. 2,300, the intrinsic value of the option is Rs. 100.
The extrinsic value of the option, also known as time value, is the amount by which the option price exceeds its intrinsic value. Extrinsic value reflects the probability that the stock price will move in the desired direction before the option expires.
If the option has a total premium of Rs. 120, and its intrinsic value is Rs. 100, then the extrinsic value is Rs. 20.

Option Price = Intrinsic value + Extrinsic value

Intrinsic Value:

It is the actual value of an option if it were to be exercised immediately.
It is calculated as the difference between the current stock price and the option’s strike price.
For a call option, the intrinsic value is the stock price minus the strike price, while for a put option, it is the strike price minus the stock price.
Intrinsic value cannot be negative.
Intrinsic value increases as the stock price moves in favor of the option.

Extrinsic Value:

Extrinsic value is also known as time value.
It is the additional value of an option over and above its intrinsic value.
It is the amount that the option buyer pays to the option seller as compensation for the risk taken.
Extrinsic value is affected by factors such as time to expiration, implied volatility, and interest rates.
Extrinsic value decreases as the option approaches expiration.