The Intrinsic and Extrinsic Value of Options

Options are among the most versatile instruments available in financial markets. To use them effectively, understanding how their prices are derived is essential. The price or premium paid by the option buyer to the seller reflects two fundamental components: intrinsic value and extrinsic value. These values together form the complete pricing structure of an option.

Let’s explore both in detail and understand how they shape options trading strategies on platforms like m.Stock.

What Is the Intrinsic Value of an Option?

Intrinsic value refers to the difference between the current market price of the asset and the option’s strike price, but only when it is favourable for immediate execution. In other words, it is the real, tangible value of an option if exercised right now.

This value is never negative, at the most it could be zero, but never less. Intrinsic value varies depending on whether you are dealing with a call or a put option.

Intrinsic Value of a Call Option

A call option grants the right (but not the obligation) to buy the underlying asset. Traders purchase calls when expecting a price rise. For a call to have intrinsic value:

• The market price must be higher than the strike price.
• Intrinsic Value = Market Price – Strike Price

For example, if the strike price is ₹17,300 and the market price is ₹17,450, the intrinsic value is ₹150.
If the market price is below the strike price, the intrinsic value is considered zero, as exercising the call would yield no gain.

Intrinsic Value of a Put Option

A put option gives the right( but not the obligation) to sell the asset. Puts are typically bought when expecting the asset price to decline.

• The strike price must be higher than the market price.
• Intrinsic Value = Strike Price – Market Price

For instance, if the strike price is ₹17,500 and the market price is ₹17,300, the intrinsic value is ₹200.
Again, if the strike price is below the current market price, the intrinsic value is zero, as it wouldn’t make sense to sell lower and buy back higher.

What Is the Extrinsic (Time) Value of an Option?

Extrinsic value, also known as time value, represents the additional premium paid over the intrinsic value. It reflects the potential for future profitability before the option expires.

Formula:

Extrinsic Value = Option Premium – Intrinsic Value

This value is influenced by several factors:

• Time left to expiry
• Market volatility
• Investor sentiment

The more time an option has until expiration, the higher the chance it could move in-the-money (ITM), hence a higher extrinsic value. Similarly, greater volatility increases uncertainty and thus raises the extrinsic value.

As expiry nears, the time value decays and eventually drops to zero if not exercised. This is a crucial consideration for options buyers.

Extrinsic Value of Call and Put Options

Whether it’s a call or put, extrinsic value is calculated the same way, by subtracting intrinsic value from the total premium.

Let’s say a call option has:

• Premium = ₹200
• Intrinsic Value = ₹150
• Then, Extrinsic Value = ₹200 - ₹150 = ₹50

This same logic applies to put options.

Tables usually illustrate this for different strike prices, highlighting how extrinsic values vary even when premiums may appear similar.

Why Intrinsic and Extrinsic Value Matter in Option Trading

Knowing how to break down an option’s price into intrinsic and extrinsic components is essential for strategic trading.

• Buying ATM or OTM options: These typically carry no intrinsic value, meaning the entire premium is extrinsic (time) value. If the option expires without going in-the-money, the premium paid becomes a loss. However, they also carry the potential for high returns if there’s a significant move before expiry.
• Buying ITM options: These come with a higher intrinsic value and thus are less likely to expire worthless. However, they also cost more, and the percentage return may be lower compared to OTM options if the move is not large.

Essentially, it becomes a risk-reward trade-off:

• ITM = Higher cost, lower risk, modest gain
• OTM = Lower cost, higher risk, larger potential gain (if successful)

Understanding this trade-off is critical when using m.Stock or any platform to create effective options strategies.

Points to Remember

• The option premium is the price paid by the buyer to transfer risk to the seller.
• The Black-Scholes model is widely used to determine theoretical option pricing.
• Every option’s price is made up of two parts: intrinsic value and extrinsic value.
• Intrinsic value is the immediate gain if the option were exercised now.

Extrinsic value, or time value, reflects potential future gains and decreases as expiry nears.