Extrinsic Value

What Is Extrinsic Value?

Extrinsic value is the part of an option's option premium that is not explained by its intrinsic value. Intrinsic value is what an option would be worth if it were exercised right now. Anything above that amount is extrinsic value, sometimes called time value, because it mostly reflects how much time remains until expiration and how much the market expects the underlying stock to move.

How It Is Calculated

The calculation is simple:

Extrinsic Value = Option Premium - Intrinsic Value

For a call option, intrinsic value is the amount by which the stock price is above the strike price, or zero if it is not. For a put option, it is the amount by which the strike price is above the stock price, or zero. An option priced at or below its intrinsic value has no extrinsic value.

For example, suppose a stock trades at 52 and a call option with a strike price of 50 costs 3.00 per share. The intrinsic value is 2.00, so the extrinsic value is 1.00.

What Drives It

Several factors affect extrinsic value:

• Time to expiration: more time generally means more extrinsic value, because there is more opportunity for the price to move favorably.
• implied volatility: higher expected price swings generally raise extrinsic value.
• Interest rates and dividends: these also influence option pricing, usually to a smaller degree.

As expiration approaches, extrinsic value shrinks, a process known as time decay. The decline tends to speed up in the final weeks before expiry. By expiration, extrinsic value is generally zero.

Why It Matters to Investors

Extrinsic value represents the cost of the flexibility that option buyers pay for and the compensation that option sellers receive for taking on risk. Because it decays over time, an option buyer can lose money even if the stock price stays flat, while an option seller can benefit from that decay. Understanding extrinsic value also helps explain why an option's price can change even when the underlying stock does not move.