Extrinsic Value
Extrinsic value measures the difference between the market price of an option, called the premium, and its intrinsic value. Extrinsic value is also the portion of the worth that has been assigned to an option by factors other than the underlying asset's price. The opposite of extrinsic value is intrinsic value, which is the inherent worth of an option.
Definition: Extrinsic value refers to the difference between the market price (premium) of an option and its intrinsic value. It reflects the market's expectations of the option's future potential volatility. Extrinsic value is determined by factors other than the underlying asset's price. In contrast, intrinsic value is the inherent value of the option.
Origin: The concept of extrinsic value originated from the development of option pricing theory, particularly the introduction of the Black-Scholes model. In 1973, Fischer Black and Myron Scholes published their paper, proposing a mathematical model to calculate the theoretical price of options, which considered factors like time value and volatility, thus introducing the concept of extrinsic value.
Categories and Characteristics: Extrinsic value is primarily determined by two factors: time value and implied volatility.
- Time Value: The longer the time until the option's expiration, the higher the extrinsic value, as there is more time for the underlying asset's price to move favorably.
- Implied Volatility: The higher the market's expected volatility, the higher the extrinsic value, as greater volatility implies higher profit potential.
Specific Cases:
- Suppose a stock is currently priced at $100, and a call option with a strike price of $105 is priced at $3 in the market. The intrinsic value is $0 (since $105 is above the current stock price), so the extrinsic value is $3.
- Another example is a stock currently priced at $100, and a put option with a strike price of $95 is priced at $7 in the market. The intrinsic value is $5 ($100 minus $95), so the extrinsic value is $2.
Common Questions:
- Why does extrinsic value decrease over time? This is because as the option's expiration date approaches, the time value gradually decreases, eventually reaching zero at expiration.
- What is the relationship between extrinsic value and implied volatility? The higher the implied volatility, the higher the extrinsic value, as the market expects greater volatility in the underlying asset's price.
