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Lesson 6:

Understanding extrinsic value

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Extrinsic value represents the portion of the option's premium that extends beyond its intrinsic value. It's composed of two main elements: time value and implied volatility. Time value is anchored in the time remaining until the option's expiration—the more time there is, the higher the premium, as it gives the underlying asset more opportunity to move in a favorable direction. Implied volatility represents the market's expectation of the underlying asset's price fluctuations, often driven by events such as earnings announcements which can cause significant price movements. In this lesson, we will concentrate on unraveling the intricacies of the time value component and how it impacts the pricing of options.

As we delve deeper, let's examine additional examples with ABC stock priced at $105 per share. This time, we'll compare call options that share the same strike price but have varying expiration dates. Each call option grants the holder the right to purchase shares of ABC at the strike price any time before the option expires.

Lesson 6: Understanding extrinsic value

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With ABC's stock price at $105, we consider several in-the-money call options with a strike price of $100 but different days to expiration (DTE):

  • Each option has an intrinsic value of $5, the result of being able to buy ABC shares at $100 and sell them at the current market price of $105.
  • The option with 0 DTE has no extrinsic value left, meaning it's worth exactly its intrinsic value of $5 on the expiration day.
  • The extrinsic values for options with 30, 45, and 60 DTE are $3, $4, and $4.50, respectively. The extrinsic value is higher for options with more DTE because they have more time for the underlying asset to potentially move in a favorable direction.

The reduction in extrinsic value doesn't happen at a steady rate. As we observe in the provided examples:

  • The option's value decreases by $0.50 from 60 DTE to 45 DTE.
  • It then drops by $1 between 45 DTE and 30 DTE.
  • The decay becomes even more pronounced as the option approaches the expiration day. This illustrates how the decaying extrinsic value is non-linear. It does not move in equal increments.

Lesson 6: Understanding extrinsic value

Key Takeaways

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1. The time value, a key component of an option's extrinsic value, diminishes as the expiration date draws nearer.

2. This decay is not linear; the rate of time value loss increases the closer the option gets to expiration.

3. On expiration, an option's premium will reflect only its intrinsic value, which may be zero if the option is out-of-the-money.

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Lesson 6:

Knowledge Check

Lesson 6: Understanding extrinsic value

Knowledge Check

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What is extrinsic value in an options contract?

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Lesson 6: Understanding extrinsic value

Knowledge Check

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Why might an option with 30 days to expiration (DTE) have a higher premium than one with 0 DTE?

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Lesson 6: Understanding extrinsic value

Knowledge Check

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What happens to the extrinsic value of an option as it gets closer to its expiration date?

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You have completed The Foundation - Lesson 6:

Understanding extrinsic value

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