What is Extrinsic Value in Options Trading?

If you are an options trader, you have to be well-versed with the concept of extrinsic value. The extrinsic value is the additional value of the option contract, excluding its intrinsic value. It is calculated by subtracting the intrinsic price of the option from its market price. While the intrinsic value refers to the real, or inherent, value of the option, the extrinsic value is the amount from the option’s current price that exceeds its intrinsic value.

The extrinsic value, also referred to as the time value, changes drastically as the contract nears the expiry. At the expiration of the option contract, the extrinsic value becomes zero. Also, a longer duration for contract expiry would mean higher extrinsic value

The amount of time left for expiration of the option contract, and the implied volatility – which is a measure of the risks and uncertainty associated with the future movement of the asset, are the key factors that influence the extrinsic value. The extrinsic value of the option is also inversely related to the option’s intrinsic value, which means the extrinsic value decreases as the intrinsic value increases, and vice versa.

To understand in detail the extrinsic value of the option, how it is calculated, and why it becomes important for traders to make informed trading decisions, read on through this comprehensive article.

Key Terms for Understanding Extrinsic Value

Before delving further into the concept of extrinsic value, it is important to understand the broader paradigm in which it is used and the key terms and concepts that are associated with it.

• Options Trading: It is a contract that gives a non-obligatory right to buy or sell an underlying asset at a specific price on or before the expiration of the contract. When the contract is to sell the underlying asset, it is referred to as the put option, and when the contract is to buy the underlying asset, it is referred to as the call option.
• Strike Price: It is used to describe the specified, pre-determined price at which the holder of the price can execute the trade, that is, sell or buy the asset.
• Expiration Date: It refers to the predetermined time period when the option contract will cease, following which the holder cannot execute the trade.
• Option Premium: It is the non-refundable fee of the contract which is paid by the option buyer to the option seller.
• Intrinsic Value: It is the real value of the asset and does not include the additional value which comes from factors like time and volatility.

Formula for Extrinsic Value

The extrinsic value of an option contract can be calculated by a simple formula:

Extrinsic Value = Option Premium – Intrinsic Value

For example, if the option premium of the contract is र2,000 and its intrinsic value is र1,800, then the extrinsic value would be र2,000 – र1,800 = र200. Unlike the intrinsic value, the formula for extrinsic value is the same for put option as well as call option.

Factors Affecting Extrinsic Value

The extrinsic value of the option contract is volatile and changes consistently. There are several factors that influence this extrinsic value.

Time left for expiry

The extrinsic value of the option contract is directly influenced by the time left for the expiry of the contract. When the duration for the expiration of a contract is lengthy, it means that the underlying asset has a considerable time to move favourably for the holder and thus the extrinsic value remains high.

On the other hand, when the expiration of the contract is nearing, which means little time is left for the underlying asset to move favourably for the holder, the extrinsic value declines till it reaches zero at the time of the expiry of the contract.

Implied Volatility

Unlike historical volatility, which is the measure of the past performance, the implied volatility is the forecast of future volatility. This perception-based measure of volatility heavily influences the extrinsic value of the option contract. The implied volatility, here, is the measure of uncertainty and the estimated size of movement that the underlying asset can have in future.

Since option trading involves future buying and selling, the implied volatility gives an idea about the future movement of the underlying asset. Therefore, when the implied volatility is high, it opens a window of possibility for higher profit, and thus the extrinsic value goes up. Inversely, when the implied volatility is low, the extrinsic value goes down.

Dividend and Interest Rate

In certain cases, where the underlying asset in the options contract is associated with dividends and interest rate, it influences the extrinsic value of the option. The extrinsic value decreases, in case of a put option, and increases, in case of call option, when the interest rates are higher.

Conversely, the extrinsic value decreases, in case of a call option, and increases, in case of put, because of expected dividends.

Difference between Extrinsic Value and Intrinsic Value

The extrinsic value of the option has an inverse relation with its intrinsic value. The two values are, however, essential for traders who want to make informed decisions in options trading. Here is the list of differences that sets the two values apart.

Conclusion

Extrinsic value is one of the two key components of options trading and is a crucial factor in forecasting and determining the future performance of the underlying asset. A proper understanding of this value will definitely assist a trader in making informed investment decisions when it comes to option contracts.

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