An option’s extrinsic value, or time value, is the premium beyond its intrinsic value. Extrinsic value represents the potential future value based on external factors such as time, volatility, or both.
Extrinsic value is the additional premium beyond intrinsic value that someone is willing to pay for the option before expiration. Key factors include implied volatility and time decay. If an option costs $4, but its intrinsic value is $1, the remaining $3 is extrinsic value. Options have no extrinsic value at expiration because there is no time value.
Extrinsic value vs. Intrinsic value
Extrinsic value is the portion of an option’s price that is not intrinsic value. Intrinsic value is the amount an option in-the-money (ITM) or the difference between the underlying asset's current market price and the option contract's strike price.
For example, assume a stock is trading at $50, and a call option has a $50 strike expiring in one month. The call option has no intrinsic value because it is not ITM; however, it still has extrinsic value because of the time until expiration. Before expiration, there is a chance the stock’s price will increase, and the call option will move in-the-money. Therefore, you are paying for this opportunity when you purchase this call.
If a stock trades at $60, the $50 strike price call option has an intrinsic value of $10 ($60 - $50 = $10). If you exercised the option at expiration, it would be worth $10.
The extrinsic value can also be considered the time premium or cost of buying an option contract. This cost represents how much investors will pay for the time remaining on the contract before expiration. The more time remaining until expiration, the higher the premium because there is a greater chance that something could happen during this period that could impact the underlying asset’s price.
As expiration approaches, the extrinsic value decays rapidly until only intrinsic value remains.
Calculating extrinsic value
To calculate an option’s extrinsic value, subtract an option’s strike price from the stock’s current market price.
For example, if an option has $5 of intrinsic value but its premium is $8, it has $3 of extrinsic value.
Factors that influence extrinsic value
The main factors influencing an option’s extrinsic value are time until expiration, volatility, interest rates, and dividend yield. Time until expiration has the most significant impact on extrinsic value because it affects how much time a stock has to move for the option to be profitable. The more time remaining until expiration, the more expensive an option will be.
Every day an option loses time value as it approaches expiration. Options time decay is not linear. Time decay accelerates as the contract nears expiration, especially for near-the-money options.
Volatility also affects extrinsic value because it implies how far a stock can move within a given timeframe. Higher volatility increases an option's price because there is more potential for large price swings. Options with low volatility have less value because there is less potential for large price swings.
Interest rates and dividend yields also have a small impact on extrinsic value. Higher interest rates make options more expensive because investors can potentially earn higher returns from other investments. Dividend yields have a similar effect since investors can earn income from stocks instead of buying options.