There are three factors that determine the premium charged for an option contract. Intrinsic value, time value, and extrinsic value. I’ve discussed intrinsic value vs time value in other articles so today I’m going to talk about extrinsic value.
First off, here’s a quick recap of what intrinsic and time value represent.
Intrinsic value relates directly to the share price of the underlying stock and represents the actual profit that will be gained should the contract be immediately exercised. There’s no guesswork here – if an option contract is in the money it will be in the money a specific amount determined by the current share price of the stock and the strike price of the option contract. That amount, the per share profit based on how far the contract is in the money, represents the intrinsic value of the premium.
Time value represents the potential for profit based on the amount of time left before the option contract expires. The farther that date is from today, the more potential there is for the price of the underlying stock to move closer to the strike price of the option so the more valuable the contract becomes. The closer to expiration date you are the less time there is for price movements and the lower the time value of the premium until, at expiration, time value has fallen to zero.
Both of these components of premium are fairly easy to estimate. Intrinsic value is fixed to share price and time value is fixed to contract expiration date. As time passes, intrinsic value rises and falls based on movements in share price and time value steadily declines until the option expires.
What neither of these values takes into account is the underlying volatility of the stock in question. That’s where extrinsic value comes in.
Everything else being equal, an option contract with an underlying stock that’s very volatile will tend to have a greater premium value than one that’s less volatile. More volatility equals more potential for price movements equals more potential for profit should those price movements happen in your favor.
Two options contracts with three days left until expiration will have the same time value but that time value will be amplified or dampened by how likely the stock they cover is to make substantial price movements during those three days. A more volatile stock will be more likely to move and earn a higher premium than a less volatile stock that will be less likely to move during the same time period.
So, extrinsic value represents that part of the premium value that represents opportunity. That represents trader’s beliefs about the contract’s potential for profit. If this portion of the premium value didn’t exist, there would be no reason to trade contracts as their premium value would have no component to factor in risk and the idea that two different traders might have two different opinions about the probability of profit from a particular contract.
Many option traders lump time value and extrinsic value together to represent the portion of the premium that’s variable and outside the actual intrinsic value of the option contract. For the sake of brevity, when I discuss premium I’ll typically do the same thing but it’s important to remember that time value is actually made up of two distinct concepts.
One, the amount of time before contract expiration, offers a relatively calculable risk while the other, trader’s opinions about the potential volatility of a stock before expiration, is extremely variable and that variability is what creates your opportunity for profit when trading options.
