What is the Extrinsic Value of an Option?

Components

The following hierarchy shows the contributors to the option value and the factors affecting these components:

  • Intrinsic value is impacted by the spot price at the time of maturity, the exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of the option, cash flows of the underlying, and the risk-free rate used for discountingThis is affected by the time to maturity or the expiry of the option and the volatility of the underlying

Factors Affecting the Extrinsic Value

  • Time value, also known as the time value of decay, represented by the options greek ‘theta’ and therefore also known as theta decay, exists because the option buyer believes that in the given time to maturity, the price of the underlying might become favorable and therefore, it is believed that longer the time to expiry, greater is the time value.And as the time to expiry keeps reducing, this value keeps on decaying. At the time of expiry, this value is equal to zero, which is why it is known as the time value of decay.Volatility (option greek: ‘vega’) of the underlying has a direct relationship with the extrinsic value because the buyer buys it to hedge himself. If he believes that the underlying value is not too volatile, he would never be willing to pay the price of purchasing the option.Therefore, if the underlying is highly volatile, the buyer can benefit from it as options have unilateral risk. If the option is in the money, it will be exercised, while if it is out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more, it will not. So higher the volatility of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more, the higher the risk for hedgers, and the higher the extrinsic value leading to higher option value.Having explained the factors and their relationship with the extrinsic value, we still need to understand that measuring the extrinsic value is not an easy process. At times, there are different option values from different analysts because of their difference in opinion about the volatility measure.

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Extrinsic Value Example

  • As we have mentioned in the introduction, an option value has two components, intrinsic and extrinsic. When the investor purchases the option, the exercise price is either equal to or lower (higher) than the current spot price of the underlying for a call (put) option. This implies that the intrinsic value is 0. In the case of a call (put) option, the option has a positive payoff when the spot price at maturity is greater (lower) than the exercise price.Even with a 0 intrinsic value, the investor pays the premium to purchase the option. So, the entire premium is due to the extrinsic value.For example, if the exercise price for a call option is $100, and the Spot price of the underlying is either $100 or less, the payoff is 0. Let’s suppose that during the time of the option, the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more becomes 110. The payoff is 110-100 = $10, and lets us say there are three months to expiry. We feel that the underlying can go up to $120, so the option price will be higher than the current payoff of 10, maybe $15, this addition of $5 is due to extrinsic value, more precisely, time value if volatility is constant.

Option Pricing Methods

Based on the lengths of the interim periods from the time of purchase of the option till the time of maturity, there are two popular methods used for option pricing, the binomial method, when the periods are discrete such as two years, and the BSM method and its variants such as the Black method, when the desired pricing is continuous.

The price arrived at in any of these methods encompasses both the intrinsic and extrinsic value of the option. If the market price is even higher than this price, then there can be two reasons for this:

  • Either there is an arbitrageAn ArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security’s price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more opportunity.Or the estimates of volatility are amiss. At times we back-calculate the volatility from the option’s current market price, which is known as the implied volatility. In contrast, there is another method for volatility calculation known as the historical method.

Assumptions of the Black Scholes Model

We need to also look at a few assumptions of the BSM because some of these are very simplistic as compared to a real-world scenario:

  • We assume that the volatility of the underlying is known and constantThe risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is known and constantThe underlying has no cash flowsThere are no transaction cost or taxes

However, these assumptions do not always hold in the real world; therefore, the BSM model requires adjustments to incorporate such variance. Such adjustments vary from analyst to analyst, and therefore there might be a possibility that the price calculated from these methods may vary from the current market price.

We need to understand from this that it is not always the case that the market price – intrinsic value = extrinsic value, and here is the difference between the terms price and value of the option. Price may refer to the market price, the value may refer to the calculated price from one of these models, and premium may refer to the amount paid when purchasing the option.

The formula for BSM for calculation of a call option price is below for understanding:

Source: Wikipedia.org

  • Without going into too much depth, we only should understand the points from the perspective of this article.The standard deviation is the symbol for volatility, and the T-t is the time till expiry. Therefore the formula suggests that the price calculated using this model incorporates extrinsic and intrinsic value variables.

Conclusion

  • We understand that the option’s extrinsic value is one of the components of the option’s total value, existing due to time value and the impact of volatility of the underlying asset.Calculating extrinsic value may not always be easy because of the variation in calculating the volatility input of the option pricing methodology. However, if we use the option’s market price to back-calculate the volatility, such volatility is known as implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.read more.Implied volatility can only be calculatedImplied Volatility Can Only Be CalculatedImplied volatility is one of the important parameters and a vital component of the Black-Scholes model, an option pricing model that shall give the option’s market price or market value. The implied volatility formula shall depict where the underlying volatility in question should be in the future and how the marketplace sees them.read more if we know the market price and, therefore, can’t be predicted accurately, making the predictability of extrinsic value extremely difficult.

This has been a guide to What extrinsic value is & its Definition. Here we discuss the components of extrinsic value and its factors, along with examples. You can learn more about it from the following articles –

  • Option ChainOption AgreementOption Contract DefinitionPut Option Definition