Options Basics Lesson 3: Intrinsic and Extrinsic Value

This Options Trading lesson is focused on Intrinsic, and Extrinsic value. Since this is a concept that some people take time to grasp, I will explain the two definitions in a couple of different ways.

First of all. What are the definitions of Intrinsic, and Extrinsic value in relation to trading Options?

• Intrinsic Value refers to the In the Money options found on the option chain. It deals with the relationship of a specific strike to the actual price of the underlying stock. For example: If you purchased the $20 call strike on XYZ, and the value of the stock increased to $30, then the Intrinsic Value of your option is $10. Note that the Intrinsic Value will never go below 0. If the math brings your Intrinsic Value below 0, then all of your strikes current value falls into the Extrinsic side.
• Extrinsic Value refers mainly to the Out of the Money options. Extrinsic Value is based on the time the option has left until expiration. These Out of the Money options tend to decay in value rather quickly over time because they lack any real value other than the probability that they will become valuable at some point in the expiration cycle. In the Money options will have both Intrinsic, and Extrinsic value, but Out of the Money options will only ever have Extrinsic value associated with them.

Another way to look at these terms is to simply look at them as Real Value vs. Time Value. When you buy or sell an option, these two factors will affect the price. An option with Real value (Intrinsic) will always have some Time value (Extrinsic) built into it, and because of this, the option is able to keep its value over time better than an Out of the Money option with just Time value. This is why it's always smart to purchase options that have real value (ITM), and to sell options that have time value (OTM), but that is a lesson for later. 

Here is a visual representation of the Option Chain with the Intrinsic and Extrinsic values for your viewing:

As you can see, Intrinsic value only relates to any strike that is ITM, but both ITM, and OTM Calls, and Puts have Extrinsic value because of the time left until expiration. 

That sums up this lesson! Next lesson will deal with the basic definitions of the Greeks. Don't forget to leave your comments and questions below.

Previous Lesson | Next Lesson