February 21, by m slabinski. You are intrinsically motivated because you like learning about investing and you are extrinsically motivated because learning can help you make more money. Ok, all jokes aside, we often get asked about intrinsic and extrinsic motivation as it relates to options trading so we wanted to break it down for you. The dictionary definition boring, I know, but essential to understand what intrinsic and extrinsic value represent in terms of options of intrinsic is "belonging to the essential nature of a thing.
Well, options can be made up of intrinsic value, extrinsic value, or both! The intrinsic value of an option is the tangible value of the option at expiration the value is the nature of the option. The extrinsic value of an option represents the external factors that can impact the intrinsic value like time and volatility external factors.
The total value of an option can be broken down into two parts: The intrinsic value when it comes to the options trading world, is how much an option would be worth if it expired right now.
If all the time on an option suddenly disappeared and it was exercised, how much would you make not including additional fees?
An option should never be worth less than its intrinsic value. If an option was ever being sold for less than its intrinsic value, experienced traders would buy the option and exercise it immediately for the intrinsic value. The profit they would make would be equal to the difference between how much they paid for the option and the amount they get for exercising it less commission fees.
Remember, options specifically American options can be exercised at any time before they expire. Options are always worth a minimum of their intrinsic value because they can be exercised for their intrinsic value at anytime. Options only have intrinsic value if they are in the money. The amount that an option is in the money by, is the same as the amount of intrinsic value an option has.
Puts are in the money have intrinsic value if their strike price is above the current stock price. If the strike price is higher than the current stock price, you will be able to sell the stock for more than it is currently worth. If an option has no intrinsic value at expiration out of the money , it will expire worthless.
How could we find the intrinsic value from those bits of information? So, in using our example, the equation would look like: In the picture to the right, we can see how the intrinsic value in red and extrinsic value in blue add together to form the option's total value. If the strike price is below the current stock price you will be able to buy stock for less than it is currently worth. Like puts, if a call option has no intrinsic value at expiration out of the money , it will expire worthless.
For simplicity sake, let's look again at COST. If intrinsic value is what the option is worth if it expired right now if we took away all the time The easiest way to think about extrinsic value is this: As an equation, it looks like:. So why on earth would anyone pay more for an option than what it could be exercised for?
Another way to understand extrinsic value is this: The amount of time left until expiration and the volatility of the underlying we will look at these briefly in the next section , directly impact the price of an option, thus impacting the extrinsic value.
Options cost significantly less money than buying stock outright because options have expiration dates, while stocks do not. As stated before, traders are hoping that the options price will change in their favor. Essentially, the market is aware the price may change so added premium extrinsic value is included to compensate for the changes in time value and volatility.
The more time an option has until expiration, the more time the underlying price has to change. Thus, the more time the option has until expiration, the more valuable the option becomes.
Aside from time value, implied volatility also makes up the extrinsic value of an option. Implied volatility effectively measures how much the stock price may swing over a specific timeframe. Adding volatility to time value, gives us the extrinsic value of an option.
If volatility in an underlying decreases, the extrinsic value of the option will also decrease. If an option has a longer contract or higher implied volatility, the extrinsic value of the option will increase.
You can see this in the option chain pictured above comparing options with the same strike price, but with longer or shorter timeframes. Would you like to test yourself on the options knowledge you just picked up?
Try answering the questions below. More questions about intrinsic and extrinsic value? Reach out to our support team at support tastytrade.
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Strike price is an important options trading concept to understand. This post will teach you about strike prices and help you determine how to choose the best one. To which the judge would reply with something like What do intrinsic and extrinsic value mean when it comes to options? Intrinsic Value The intrinsic value when it comes to the options trading world, is how much an option would be worth if it expired right now.
How to Calculate Intrinsic Value? What does intrinsic value mean for different option types? Intrinsic Value For Puts. Intrinsic Value For Calls.
How did we get that number? Then what is the extrinsic value? As an equation, it looks like: In the example to the right, the equations would be: Time Value Days To Expiration. Implied Volatility Aside from time value, implied volatility also makes up the extrinsic value of an option. What is the intrinsic value of the following calls?More...