I have incorporated this topic into my other article, but I wanted one that focused on this topic so I can reference it as necessary for future options trades. Understanding intrinsic value and extrinsic value can help you identify profitable opportunities. Remember options are an agreement to buy or sell the underlying stock at the strike price.
First you should recall the difference between out-of-the money (OTM) and in-the-money (ITM). Options have strike prices, and OTM and ITM mean being on the wrong side of that.
- For Calls – ITM means the current stock price is above the strike price. OTM means the current stock price is below the strike price.
- For Puts – ITM means the current stock price is below the strike price. OTM means the current stock price is above the strike price.
I saw wrong side, because I think of options as a buyer, rather than a seller. For those who sell, or write options, the “wrong” side is switched.
Options have value due to their duration. When a contract is held open there is value in giving up that absolute control over your own actions. Agreeing to buy or sell a stock when someone else asks you to is a right that costs. It is options writers that profit from this value. As options buyers, we pay this premium. Premiums go down as we get closer to the expiry date. Remember when you buy an option it is for a set duration.
For OTM options, all the value is extrinsic. That value is determined by complex math dealing with volatility, amount of time, and other factors. Try not to worry about that too much.
Intrinsic value is the inherent value in the option. Think about extrinsic value as a surcharge to hold your place in line. Say you wanted to pre-order a video game, and rather than just charging you when it ships, or even giving you a discount as they sometimes do now (or offering other perks) they charged you to pre-order. The game would open at $50, but if you want to pre-order it will be $60. Well consider that its resale value is 100%. Then it has $50 of intrinsic value, and $10 of extrinsic value. that $10 disappears once the game is released at $50. Now this would not normally happen with a product like a game. Holding a place for a trade in the future is valuable because the price could be wildly off the strike price, but you might be forced to buy and sell.
Example: Strike for call is $50, price is $100. You give the right to someone to take your shares at $50 even if the price is $100. If you are on the other side you should be paying for that right. Now normally you paid a price when it was OTM like if the current stock price was $45 you pay $1 for the right, but it goes on the rally to end all rallies and then you are holding something that is exceptionally valuable. Because of that potential the right contained in the option has value.
Now back to the $50 video game. It has $50 dollars of intrinsic value. Let us say that you bought it for that price (ignoring the pre-order price), but demand is higher than they thought and they just jack up the price (in retrospect I should have gone with wine because it can behave this way, while video games don’t). Now it is $100 dollars for the game. Your video game now has an intrinsic value of $100, considering what you paid for it ($50) you now have $50 of intrinsic profit. This is inherent to the asset itself.
For options, once you cross the strike price (above for calls, below for puts) the option tracks 100% of the value of the underlying stock. There will still be some extrinsic value left over depending on how much time is left, but as you get more ITM you can worry about this less. The key point is that when an option goes ITM 100% of the move of the underlying stock is captured.
The implications of this for surprises is huge. You get a nice cheap call, and the price jumps way past your spike, as good as owning it at the strike, with hopefully some premium still built-in. If you are lucky and called a move with plenty of time on the clock you’ll get some premium appreciation too. That way you gain from the underlying stock as well as anticipation.
Intrinsic Value – The value inherent in the option, which is the current stock price minus the strike price. There is no value for OTM options. Intrinsic value will not match the price of the option, because of the premium. Example: Stock is $6.00, you have calls at $5. There is $1 of intrinsic value in the call ($100 dollars of intrinsic value). The price might be $1.10, or whatever. The excess over the intrinsic value is the extrinsic value. Intrinsic value is always 100% of the amount over your strike.
Extrinsic Value – The value that is separate from the underlying asset, also called the premium. This is pure anticipation and time value. Extrinsic value of an OTM option is its face value (remember options are 100x so an option that is $0.10 is worth $10). Extrinsic value of an ITM option is the face value minus the intrinsic value. This one is tricky: Stock is priced at 5.05, you have calls with a strike of $5 and its face value is $0.10, $10 per call. There is $0.05 of intrinsic value and $0.05 of extrinsic value.
This topic is also relevant to stocks in general. There is a difference between the price and the underlying value of a stock. Check this fantastic article over at Stockodo.