Intrinsic Value and Extrinsic Value

Intrinsic Value

An option has intrinsic value when it is in-the-money. For an in-the-money call the intrinsic value is equal to the underlying asset price less the strike price. For an in-the-money put, the intrinsic value is equal to the strike prices less the underlying asset price. An option has no intrinsic value if it is out-of-the-money; its extrinsic value is equal to the price of the option.

Extrinsic Value

The time value of an option is the Extrinsic Value (also called as "Time Value"). The Extrinsic Value equals the option price minus the intrinsic value of the option. Out-of-the-money options are composed entirely of extrinsic value, which have no intrinsic value.

More about Intrinsic and Extrinsic Value

The price at which an option can be exercised, is the Strike Price. The right to buy the underlying asset at the strike price is a call. The right to sell the underlying asset at the strike price is a put.

The whole purpose of options is to deliver a right to sell or buy an underlying stock at specific price. If you are buying QQQ $40 call options and at the expiration QQQ stock is traded at $45 then you realize $5 profit at expiration. For this right to buy or sell at specific price an options buyer has to pay premium to the options seller.

The options premium could be divided into two parts: intrinsic options value and options time value. The intrinsic value is a difference between the current underlying stock price and the strike price of the option contract. The other part of the options premium is an options time value - the price for the risk that is paid to the options seller. let's take a look at several examples to better understand the option intrinsicvalue:

Example #1: You are buying in the money QQQ 40$ call options at $2,40 per contract and QQQ stock is traded at $39 at that moment. The QQQ call options will expire in 2 months

The difference between strike price and the QQQ stock price is $1 and this is intrinsic part of the options $2,40 premium you paid. The rest ($1.40) is a time value of the call options you are buying.

Example #2: You are buying in the money QQQ 40$ call options at $1.40 per contract and QQQ stock is traded at $39 at that moment. The QQQ call options will expire in 1 months

The example #2 is similar to the example #1 with a difference that now the options contracts are 1 month closer to the expiration. The same as in the first example, the difference between strike price and the QQQ stock price is $1 and this is intrinsic part of the options premium you paid. The rest ($0.40) is a time value of the call options you are buying. The closer to the expiration the lower options time value becomes.

Example #3: You are buying out the money QQQ 40$ call options at $1.40 per contract and QQQ stock is traded at $41 at that moment. The QQQ call options will expire in 2 months

The difference between strike price and the QQQ stock price is minus $1. Because you are buying out of the money options the intrinsic value of this options is equal to zero. The whole premium (!1.40) you paid for the options contract is a price for the risk and is options time value.

Example #4: You are buying out the money QQQ 40$ call options at $0.40 per contract and QQQ stock is traded at $35 at that moment. The QQQ call options will expire in 2 months

The same as in example #3, because you are buying out of the money options the intrinsic value is 0. Yet, because the options contracts are deeper out the money, the options seller risk is smaller and as a result the time value is lower - only $0.40 per options contract.

Below you may see summary table of the examples above

Table #1: Examples of option intrinsic and time value

Summary point to remember:

• Intrinsic value reflect difference between strike price and current underlying stock price;
• Time value is a price for the options seller's risk;
• In the money option's premium is a sum of the options intrinsic and option time values;
• Out of the money option's premium has only time value;
• At the expiration in the money option's premium has only intrinsic value;
• At the expiration out the money option's premium is 0;
• The closer to expiration - the fewer seller's risk is, and the lower time value is;
• The deeper out of the money options are - the fewer seller's risk is, and the lower time value is.