Intrinsic vs Extrinsic Value: Options Pricing Guide

Options Pricing 101

In options trading, intrinsic value is easy to calculate—it’s simply how much a call or put option is in-the-money. 

The real difficulty is determining how to value an option's extrinsic value, which includes elements such as:

• Time
• Interest rates 
• Implied volatility
• Dividends
  

It’s also important to know that different types of options have different characteristics. 

For example, European-style options can only be exercised at expiration, whereas American-style options can be exercised at any time. This means that different pricing models are used for different types of options. 

Before we get into intrinsic and extrinsic value, it will help to have an understanding of how market markers price options.

Option Pricing Models

There are three primary methods to price the premium of an option:

1. Black-Scholes Model
2. Binomial Model
3. Monte Carlo Simulation

The Black-Scholes model is most popular among index options like SPX (S&P 500 Index), which are European-style options.

The Binomial model, on the other hand, is very popular amongst market makers for pricing American-style options, which represent all stock options. This model accounts for the possibility of early exercise, something that cannot happen with European-style options. 

Intrinsic Value Calculation: Calls & Puts

Call and put options have intrinsic value when they are in-the-money. The amount an option is in the money determines how much intrinsic value that option has. Intrinsic value tells us how much value an option has if it were to be exercised at any point in time. 

Unlike extrinsic value, intrinsic value doesn’t consider external factors like time or volatility. If a stock is trading at $100, a 95 strike price call option will have $5 in intrinsic value. This holds true whether we’re 2 years away from the options expiration or just 1 minute away.

Let’s now look at the very basic math used to determine intrinsic value.

Call Option Intrinsic Value Calculation

Intrinsic Value = Stock Price − Strike Price

• If the result is positive, this is the intrinsic value.
• If the result is zero or negative, the intrinsic value is $0 (out of the money).

Example: If a call option has a strike price of $50 and the stock is trading at $55, the intrinsic value is $5 ($55 - $50).

Put Option Intrinsic Value Calculation

Intrinsic Value = Strike Price − Stock Price

• If the result is positive, this is the intrinsic value.
• If the result is zero or negative, the intrinsic value is $0.

Example: If a put option has a strike price of $60 and the stock is trading at $55, the intrinsic value is $5 ($60 - $55).

Intrinsic Value Example: Call Option

Let's examine the intrinsic value over time of a 100-strike price call option across 14 months, leading up to expiration.

What’s important to note here is that intrinsic value doesn’t change with time. When the option goes in-the-money, that amount of moneyness represents the option's intrinsic value. It’s that simple.

When the stock price falls below our strike price of 100, exercising the option would have zero value and, therefore, has zero intrinsic value. For example, why pay $100/share for a stock when the market price is $96/share? 

⚠️  Besides the initial debit paid, it is essential to consider the commissions and fees associated with most options transactions when calculating net profit or loss. These fees can significantly impact the overall return on investment and should be factored into all trades placed.

Extrinsic Value Explained

Unlike intrinsic value, extrinsic does indeed change over time. For example, let’s say you own a 605 strike price call on SPY (SPDR S&P 500 ETF Trust) when SPY is trading at $600/share. Your option will expire in 3 months. 

This option is out-of-the-money, so therefore has zero intrinsic value. But you still have three months until expiration - isn’t there a chance your option will be in-the-money on expiration? 

Of course! Therefore, this call option has extrinsic value. 

Now, on the other hand, if it’s the day of expiration and the stock is still trading at $600, there is almost a 0% chance that SPY will rally $5 to your strike price. In this scenario, your call will have $0 extrinsic value, and $0 intrinsic value, rendering it worthless, or ‘zero bid’ as we say in the industry.   

Time Value - Theta

What we just discussed is called time decay, which is represented by the option Greek theta. As an option approaches expiration, it begins to shed value. Theta tells us how much value an option will shed daily and is visible on the TradingBlock options chain. 

As we can see in the call options chain below, theta is highest for at-the-money options. These options have the most extrinsic value, which decay fastest as expiration approaches.

This is because at-the-money options carry the most uncertainty about whether they’ll end up in-the-money or worthless on expiration. As time passes, this uncertainty resolves.

At option expiration, all options have zero time value, so they will have zero theta. It is important to note that options shed value exponentially as expiration approaches—theta does not fall linearly. 

Other Extrinsic Value Inputs

Time is a massive component of extrinsic value, but not all of it. Time, in addition to the below inputs, comprise the complete extrinsic value of an option: 

• Implied volatility: How much may the underlying move?
• Interest rates: What is the opportunity cost of holding the option?
• Dividends: How will dividends affect option value?

More on dividends to come as this is a big one. 

Extrinsic Value Calculation: Calls & Puts

Here’s how you simply calculate the extrinsic value for both call and put options. Remember, extrinsic value represents all option premium that is not intrinsic value. 

Extrinsic Value = Option Premium − Intrinsic Value

Extrinsic Value Example: Call Option

Let’s look at an example of the extrinsic value of a 100-strike price call option over 14 months, ending at the options expiration.

Notice how the extrinsic value falls almost regardless of the stock price over time? That’s the time decay we spoke of earlier, slowly eating away at the option premium. 

Intrinsic/Extrinsic Value and Exercise/Assignment

Traders watch closely both intrinsic and extrinsic as they can give clues as to whether an option should be exercised (and thus assigned). 

Generally speaking, options are at the greatest risk of assignment when:

1. An Option is In-The-Money

The deeper an option is in-the-money, the higher the odds that a long will exercise their right to convert the option to stock, which increases the risk of shorts being assigned.

2. Expiration is Approaching

The odds of an option being exercised (and thus assigned) increase dramatically as expiration approaches. This is because there’s little to no extrinsic value left to capture. This gives little incentive to hold the option. On expiration, all in-the-money options are auto-exercised by brokers. 

3. A Dividend is Approaching 

Owning equities comes with rights, like receiving dividends (if the company issues them). Options, however, don’t carry these rights. Many long in-the-money call options are exercised before the ex-dividend date so the holder can receive the dividend by owning the stock. 

If you’re short an in-the-money call before the ex-dividend date, it’s best to trade out of the position to avoid the risk of being assigned.

4. Low Extrinsic/High Intrinsic Value

When an option’s value is primarily intrinsic with little to no extrinsic value left, the likelihood of it an exercise increases. Deep in-the-money options have minimal time value remaining, making early exercise more attractive to holders. 

For short positions, this means higher risk of assignment as expiration approaches.

5. Liquidity is Low

If a trader can’t exit their option in the open market for the option's intrinsic value, they may be better off exercising. Liquidity in options trading is incredibly important, but this particular scenario is rare.

Intrinsic & Extrinsic Value Example

So we’ve learned what intrinsic and extrinsic value are. Now let’s revisit our 100 strike price call option, but this time we’ll include both components that form an option’s complete value.

Intrinsic & Extrinsic Value: Real World Example

Let’s now revisit the options chain and examine the intrinsic and extrinsic value of SPY call and put options expiring in 29 days.

Let’s first look at the in-the-money 590 call (on the left) and determine what portion of the option premium is extrinsic and intrinsic value.

• Option Price: $13.16
• Stock Price: $595.23
• Intrinsic Value: Since the option strike price is $590 and the stock is trading at $595.23, the intrinsic value is $5.23 ($595.23 - $590).
• Extrinsic Value: The remaining value, $7.93 ($13.16 - $5.23), is extrinsic.

Now let’s look at the 599 call, currently priced at $7.38. 

• Option Price: $7.38
• Stock Price: $593.23
• Intrinsic Value: $0
• Extrinsic Value: $7.38 

Since this option is out-of-the-money, its entire value consists of extrinsic value.

And finally, we’ll close with the 595 strike price at-the-money put option:

• Option Price: $7.06
• Stock Price: $595.23
• Intrinsic Value: $0.77 ($596 - $595.23)‍
• Extrinsic Value: $6.29 ($7.06 - $0.77)

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