The difference between Intrinsic and extrinsic value
The two main components of an Options value are Intrinsic value and Extrinsic (time) value. It is very useful to be able to determine what component of an options value is Intrinsic and which are time and this lesson will outline how to calculate this proportion.
Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time and it is therefore the minimum value of an option.
For call options Intrinsic value can be calculated as the Underlying Stock's Current Price minus the Call Strike Price. Therefore the Time Value is the Call Premium minus the Intrinsic Value.
For Put Options the Intrinsic value is equal to the Put Strike Price minus the Underlying Stock's Current Price. Again, the Time Value is the Put Premium minus the Intrinsic Value.
At the money and out of the money options are purely extrinsic - they don't have any intrinsic value because they do not have any real value, you are simply paying for time and this decreases as the option approaches its expiry date.
The more time an option has until expiration, the greater the option's chance of ending up in-the-money. The closer you get to the expiration date, the more money you're going to lose if the Stock price doesn't move.
Using BHP as an example, on the 22/11/05, BHP was at $21.67 the call options were priced at;
November;
| strike price |
premium |
Intrinsic value |
Time value |
| 21.00 |
.73 |
.67 |
.06 |
| 21.50 |
.32 |
.17 |
.15 |
| 22.00 |
.08 |
.00 |
.08 |
The intrinsic value of an option is the same regardless of how much time is left until expiration. However, since theoretically an option with 1 month till expiration has a better chance of ending up in-the-money than an option expiring in the present month, it is worth more because of the time value component. That's why an out of the money option consists of nothing but time value and the more out-of-the-money an option is, the less it costs.
To many traders, this looks good because of the inexpensive price one has to lay out in order to buy such an option. However, the probability that an out of the money option will turn profitable is really quite slim.
With the price of BHP at $21.67, a November 21.50 call would cost $0.32. In this case, BHP would have to be at $21.99 in order for the trade to break even. If you were to buy a November $21.00 call and pay $0.73 for it, BHP would only have to be at $21.73 in order to break even. As you can see, the further out an OTM option is, the less chance it has of turning a profit. The deeper in-the-money an option is, the less time value and more intrinsic value it has. That's because the option has more real value and you pay less for time. Therefore, the option moves more like the underlying asset.