It is more important than ever to understand the different types of value that an entity can possess in today’s economy. One of the most important but often misunderstood types of value is extrinsic value.
Extrinsic value is the value that comes from outside the entity itself. It can be derived from several factors, including brand equity, market position, and customer loyalty.
While intrinsic value is often considered more critical, extrinsic value can be crucial to success. So let’s take a closer look at extrinsic value and some examples of how it can be used to create value for businesses.
What is Extrinsic Value?
Extrinsic value is the difference between the market price of an option and its intrinsic value. Extrinsic value can also be referred to as “Time value.” For example, when considering a put option or call option, time premium refers to the amount paid over the contract’s lifetime for holding the contract rather than letting it expire.
Both intrinsic and extrinsic values are significant when determining an option’s market price, the former being more highly valued than the latter. However, a contract that costs more due to extrinsic factors will also be less sensitive to changes in the market because of those same factors.
This is why a stock with high brand value will have fewer fluctuations when the market sees an overall decline.
Related: Spot Market
Basics of Extrinsic Value
Extrinsic value is the portion of an option’s worth that has been assigned to it by factors other than the underlying asset’s price.
This means that, for any given contract, there will be two components: intrinsic and extrinsic value. Intrinsic value only changes due to the movement in the stock’s price. So, for example, when the market rises, the intrinsic value of call options will increase because it is based on the stock’s price.
On the other hand, extrinsic value can increase or decrease depending on outside factors. For example, if there is a high public interest in a particular stock due to good news about its industry, the demand may increase the extrinsic value of call options.
If there is bad news about the industry, then the extrinsic value might decrease because people are less likely to invest in risky stocks like those in an unstable industry.
As you can see, extrinsic value plays a role in determining how much a stock is worth at any given time. Therefore, investors must try to get the most accurate picture of intrinsic value before investing and track extrinsic value to understand better how related factors influence their investment decisions.
Examples of extrinsic value
Assume a trader buys a put option on XYZ stock. The stock is trading at $50, and the trader buys a put option with a strike price of $45 for $3. It expires in five months.
At the time of purchase, that option has no intrinsic value because the stock price is above the put option’s strike price. Assuming implied volatility and the stock price stay the same, as the expiration date approaches, the option premium will move toward $0.
If the stock falls below the put strike price of $45, then the option will have intrinsic value. For example, if the stock falls to $40, the option has $5 in intrinsic value. If there is still time until the option expires, that option may trade for $5.50, $6, or more because there is still extrinsic value.
Intrinsic value does not mean profit. If the stock drops to $40 and the option expires, it is worth $5 because of its intrinsic value. The trader paid $3 for the option, so the profit is $2 per share, not $5.
Extrinsic value vs Intrinsic value
Extrinsic value is the actual dollar amount of an option’s worth or premium. It represents both the intangible and tangible characteristics currently reflected in the market price of an option. When extrinsic value gets small enough to outweigh any intrinsic value, then this is known as “time decay.”
Intrinsic value is the inherent worth of an option. Relatively few options have intrinsic value because most options are out-of-the-money. Intrinsic worth naturally comes with being at the money or in the capital. The closer to expiration that you get for your option(s), the more likely it is that intrinsic value will outweigh the extrinsic value.
Factors Affecting Extrinsic Value
Several different factors affect the extrinsic value of an option. These include:
1. Supply and demand for the underlying security
This is one of the most important factors that influence extrinsic value. The demand for stocks with solid prospects will increase their extrinsic value because more people are willing to buy them at a higher price, even if they have reached their intrinsic value.
Conversely, if news starts to spread about a company’s upcoming problems, its stock price will decrease, and so will its extrinsic value.
2. Time to expiration date
Time plays a crucial role in the value of an asset, so also market volatility or implied volatility. In many cases, Time Value is another name traders or analysts describe extrinsic value. Time is a determining factor for extrinsic value because whether the option premium will increase or decrease is determined by the length of time the security or underlying asset is used in the market.
The passage of time reduces an option’s extrinsic value because there is less time left for the options to be profitable. Therefore, the longer an option expires, the more likely it will be exercised.
Time is a determining factor for extrinsic value because whether the option premium will increase or decrease is determined by the length of time the security or underlying asset is used in the market.
3. Volatility of the underlying security
If a stock experiences changes in both directions, its extrinsic value also increases because it has more significant potential to increase or decrease depending on what happens next. Conversely, if the stock only sees movement in one direction, that movement results in more substantial losses or gains to the call or put option holder.
4. Implied Volatility
This is another essential factor to consider when considering the extrinsic value of an option. Finally, implied volatility is investor sentiment toward price movements and represents how much movement traders believe will happen in stock over one year.
For example, suppose there is high implied volatility. In that case, there is a greater chance that options traded on that stock will have high extrinsic value because there is a greater likelihood of substantial up or down movement in the stock’s price over time.
Related: Security Market Line (SML)
Importance of Extrinsic Value in Options
Extrinsic value is significant for options traders because it provides information about the price of an option. This allows you to make more accurate predictions about whether or not your trades will be profitable.
By understanding extrinsic value, you can choose to enter trades with high probabilities of positive returns and avoid those with lower chances. You can also use this information to help time your transactions and avoid investing in unfavorable situations where the extrinsic value is low and unlikely to increase enough for you to strike a profitable deal.
There are several different strategies that options traders can implement when trading on stocks with high levels of extrinsic value, including vertical spreads, iron condors, and straddles.
Using these strategies to get the most out of your investments while avoiding unfavorable trades allows you to maximize your profits while limiting potential losses.
Final Words
An option contract is a contract that allows the buyer to buy or sell the underlying security, which is generally stock or exchange-traded fund (ETF) shares, at a specific price. For example, put options give the right to sell the underlying stock and call options reserve the right to purchase it.
Extrinsic value is a risk parameter that measures the amount by which the value of an option is being affected by external factors other than the underlying asset prices. Extrinsic value can have positive as well as negative values.
We hope this article helped you know and understand the concept of extrinsic value. If yes, please share it with your friends and colleagues who want to learn about extrinsic value. Thanks for reading!
FAQ
Why implied volatility increase?
Implied volatility increases when there are more buyers than sellers. This is typically due to market sentiment that an increase in prices is likely, which means a rise in implied volatility for stocks and options.
What is a specified price in the options contract?
The specified price is the predetermined price at which the owner of an option can buy or sell specified security, in contrast to the stock’s current market value.
What is the difference between the market price and the strike price of the underlying security?
The market price is the current price of a stock, which can fluctuate constantly depending on the situation in the market (e.g., Stock Market). Strike prices are standardized across all options, with one strike price having the same expiration date.
What is the call option?
A call option is a contract that gives the buyer the right but not the obligation to buy a set amount of shares from the seller of the contract at a specific price within a specified period. If call options are exercised, it means you can be called upon to sell your stocks/shares for a particular price. The call option enables the call option owner to buy 100 shares of stock at a predetermined price.
What is the money option?
A money option is a contract that enables the owner to buy or sell cash. Money options are available for commodities, currencies, and indices.
What do investor purchases an option for?
An investor purchases an option to cover the downside risk. They are not buying the stock but are willing to pay the money off chance that they need protection on their investment. If the buyer of an option had no interest in owning the underlying security, it would be considered purely speculative. So investors purchase options to protect themselves against catastrophic losses beyond their control.
Is intrinsic value the difference between the underlying security’s price and the option’s strike price when the option is in the money?
Intrinsic value is the difference between the underlying security’s market price and the option’s strike price. It will always equal zero if an option is out of money. However, if it is in the capital, the intrinsic value is positive if it has a higher price than its strike price.
