Extrinsic Value

Extrinsic Value (also known as 'time value') is the portion of an option's price that is not its intrinsic value. Think of it as the “hope premium” or the speculative component of the price. If intrinsic value is the cold, hard cash value you'd get by exercising the option right now, extrinsic value is the extra amount you pay for the chance that the option could become even more profitable in the future. It represents the market's assessment of several factors, primarily the amount of time left until the option expires and the expected volatility of the underlying stock. For an option that is currently worthless (an out-of-the-money option), its entire price is made up of extrinsic value. This value is a depreciating asset; like a block of ice on a summer day, it melts away as the expiration date gets closer, a process known as time decay.

An option's total price, or 'premium', is elegantly simple. It's the sum of two distinct parts: what it's worth today and what it might be worth tomorrow.

• Price = Intrinsic Value + Extrinsic Value

Understanding these two components is the key to understanding options themselves.

Intrinsic value is the option's value based on a simple, immediate calculation. It's the amount of profit you would make if you exercised the option this very second.

• For a call option (the right to buy), intrinsic value is the amount by which the stock's current price is above the strike price (the price at which you can buy). If a stock trades at $55 and your call option has a $50 strike price, its intrinsic value is $5.
• For a put option (the right to sell), intrinsic value is the amount by which the stock's current price is below the strike price. If a stock trades at $45 and your put option has a $50 strike price, its intrinsic value is $5.

Crucially, intrinsic value cannot be negative. If an option is not immediately profitable to exercise, its intrinsic value is simply zero.

Extrinsic value is everything else. It's the premium investors are willing to pay for the uncertainty and potential that time provides. If our $50 strike call option on a $55 stock is selling for $7, its price breakdown is:

• $7 (Total Price) = $5 (Intrinsic Value) + $2 (Extrinsic Value)

That $2 is the price of hope—the hope that the stock climbs even higher than $55 before the option expires.

Several forces work together to inflate or deflate an option's extrinsic value. The two most powerful are time and volatility.

This is the number one driver of extrinsic value. The more time an option has until it expires, the more opportunities there are for the underlying stock's price to move in a favorable direction.

• More Time = More Hope = Higher Extrinsic Value.

An option that expires in one year will have significantly more extrinsic value than an identical option that expires next week. However, this value is constantly decaying. The rate of this decay is measured by a variable called theta. As the expiration date approaches, theta accelerates, and the extrinsic value melts away faster and faster, eventually hitting zero at the moment of expiration.

Volatility measures how much a stock's price swings up and down. A sleepy, stable utility stock has low volatility, while a biotech startup awaiting drug trial results has high volatility. The market's expectation of a stock's future choppiness is called implied volatility.

• Higher Implied Volatility = More Uncertainty = Higher Extrinsic Value.

Higher uncertainty means a greater chance of a large price move in either direction. Since an option holder's losses are capped at the premium paid, but their potential gains are theoretically unlimited, this increased chance of a big swing makes the option more valuable.

While time and volatility are the stars of the show, other factors play a supporting role:

• Interest Rates: Higher interest rates generally increase the extrinsic value of call options and decrease it for puts. This relates to the cost of carry—the cost of holding the underlying asset.
• Dividends: A forthcoming dividend payment will cause the stock price to drop by the dividend amount on the ex-dividend date. This tends to decrease the extrinsic value of call options and increase it for put options.

For a value investing purist, extrinsic value should be viewed with extreme skepticism. It is, by definition, a speculative premium for an uncertain future. It is not tied to the tangible, calculable value of a business. A value investor seeks to buy a dollar's worth of assets for fifty cents; paying a premium for “hope” is the philosophical opposite of this. Because extrinsic value is a depreciating asset guaranteed to go to zero by expiration, buying options (especially those that are out-of-the-money and consist entirely of extrinsic value) is often more akin to gambling than investing. However, a savvy value investor can turn this concept on its head. Instead of buying hope, why not sell it? This is the core idea behind strategies like writing covered calls against a stock you already own or selling cash-secured puts on a stock you'd like to own at a lower price. In both cases, the investor collects the extrinsic value premium from others, either generating income or lowering their cost basis. By selling options, you are paid to wait, putting the relentless decay of time value to work for you, not against you.