Understanding intrinsic and extrinsic value is crucial for anyone involved in options trading, as these concepts significantly influence an option’s price and a trader’s potential returns. If you are wondering how it matters and how these two values differ, read this article.
What is Intrinsic Value in Options?
An option’s intrinsic value represents the real, inherent value of an option, based on the current price of the underlying asset. Intrinsic value represents the inherent worth of an option by comparing its underlying asset’s market value to the strike price.
When an option reaches its price level above the strike price, it becomes “in the money,” the intrinsic value tells us this amount of profit from immediate exercise.
A call option’s intrinsic value is the difference between the price of the underlying asset and the strike price. A put option’s intrinsic value shows how much the current price of the underlying asset is less than its strike price.
Intrinsic Value Formula:
- Call Option: Intrinsic Value = Current Price of Asset – Strike Price (if the option is ITM)
- Put Option: Intrinsic Value = Strike Price – Current Price of Asset (if the option is ITM)
If the option is out of the money (OTM), its intrinsic value is zero because exercising it would not be profitable.
You can also undertake option trading courses from Upsurge.club to dive deep into these concepts.
Example of Intrinsic Value:
Imagine a trader holding a call option with a strike price of Rs. 500, and the stock is currently trading at Rs. 600. The intrinsic value of the call option is Rs.100 (Rs.600—Rs.500). If the option were exercised today, the trader could buy the stock at Rs.500, making an immediate profit of Rs.100 per share.
What is Extrinsic Value in Options?
Extrinsic value is the extra value that an option has due to factors such as the remaining time to expiration, the underlying asset’s volatility, and market conditions. The extrinsic value is the difference between the option’s intrinsic value and its total price (also known as the premium).
Extrinsic value represents the possibility of additional profits before the option expires, as opposed to intrinsic value, which is correlated with the price of the underlying asset.
Extrinsic Value Formula:
- Extrinsic Value = Option Premium – Intrinsic Value
The longer the time until expiration and the higher the volatility of the underlying asset, the higher the extrinsic value is likely to be.
Example of Extrinsic Value:
If a trader has a call option with a strike price of Rs.50, and the stock is currently trading at Rs.55. The option premium (the price you pay for the option) is Rs.8. The intrinsic value is Rs.5 (Rs.55 – Rs.50). Therefore, the extrinsic value is Rs.3 (Rs.8 – Rs.5).
Conclusion
The difference between intrinsic and extrinsic value in options trading is crucial for developing a successful options strategy. Intrinsic value reflects the real worth of an option, while extrinsic value accounts for factors like time and volatility, influencing the premium a trader pays for an option.
By understanding both intrinsic and extrinsic values, traders can make smarter trading decisions, avoid unnecessary risks, and enhance their profitability. To know more, enroll in option trading full course from Upsuge.club.
