Introduction

Retail traders usually engage in options trading. In this practice, the distinction between intrinsic and extrinsic value is a crucial aspect to understand. Understanding these two components can help traders better evaluate options contracts and develop effective trading strategies.

This article will provide an overview of intrinsic versus extrinsic value, explain how it is calculated, discuss strategies that use intrinsic and extrinsic value, and give tips for profiting from options trading using these concepts.

What is intrinsic and extrinsic value?

Every options contract contains two components of value – the intrinsic value and the extrinsic value.

Intrinsic value is the amount at which the option is in the money. For call options, it is the amount by which the strike price is less than the current market price of the underlying asset. For put options, it is the amount by which the strike price is above the current market price. The intrinsic value represents the minimum value of the option. The amount can be achieved by exercising the option and trading the underlying asset at the current market price. An option only has intrinsic value if it is in the money – if the strike price is favorable compared to the market price. Out-of-the-money options and options have no intrinsic value.

Extrinsic value is the incremental value of the option above the intrinsic value. It represents the premium paid for an option based on how profitable it is at expiration. Extrinsic value comes from uncertainty about where the underlying market price will move in the future. Factors affecting extrinsic value include time until expiration, volatility, and interest rates. Unlike intrinsic value, both in-the-money and out-of-the-money options can have extrinsic value. The extrinsic value decays over time as expiration approaches until only the intrinsic value remains.

How to calculate intrinsic and extrinsic value

How to calculate intrinsic value:

• For call options, intrinsic value = current stock price – strike price
• For put options, intrinsic value = strike price – current stock price

The intrinsic value is zero if the calculation results in a negative number.

How to calculate the extrinsic value:

Extrinsic value = option premium – intrinsic value

The option premium is the current market price of the options contract. Extrinsic value is any premium that exists over intrinsic value.

Strategies that use intrinsic and extrinsic value

Understanding intrinsic and extrinsic value opens many strategic approaches to options trading.

Here are some examples:

• Buying undervalued options: When an option’s premium is less than its intrinsic value due to mispricing, it represents an opportunity to buy an undervalued contract. This is rarely seen in liquid options.
• Selling overvalued options: When the option premium is essentially an extrinsic value with little or no intrinsic value, it may be overvalued. Consider selling the option and collecting the higher premium.
• Intrinsic earnings protection: When the option becomes deep in the money, hold your position to take advantage of continued intrinsic value. Intrinsic value acts as a buffer against losses.
• Extrinsic value decay time: When selling options, target those with a high extrinsic value that are close to expiration to maximize decay. The passage of time will erode the premiums collected.
• Practice early to get intrinsic value: If you are deep in the money, exercise the option before expiry to get the intrinsic value immediately instead of waiting.
• Subtract and up to add more extrinsic value: As expiration approaches, roll the option to a later date and even higher strike to collect more extrinsic value – delay expiration.

How to profit using intrinsic and extrinsic value

There are several ways traders can benefit from options trading using their understanding of intrinsic and extrinsic value:

• Selling overvalued options: Look for options that have a higher extrinsic value than intrinsic value. The inflated premium provides an opportunity to profit.
• Buying undervalued options: Look for mispriced options that have a lot of intrinsic value but a low premium. Low price is attractive to buy.
• Sell covered calls: When holding the underlying calls, sell the calls with the lowest intrinsic value to essentially collect the extrinsic value as a premium.
• Sale of secured sales for cash: Selling puts out of the money or at the money to maximize the external value premium collected.
• The calendar spreads: Selling short-term options with little intrinsic value and buying longer-term options with higher extrinsic value – profit with short-term decline.
• Roll out options: Closing a trade that is nearing expiration and opening a new option in time with more extrinsic value – continue to collect the premium.

Tips and tricks for trading intrinsic and extrinsic value

Here are some useful tips for trading intrinsic and extrinsic value:

• Pay close attention to the acceleration of time value deterioration over the last 30 to 60 days to expiration
• Be aware of upcoming events such as earnings that could drastically change the intrinsic value
• Use volatility to your advantage – target high volatility options to sell
• For long options, choose options that are deep in the money for a high intrinsic value
• Adjust strike prices to balance intrinsic/extrinsic value based on expectations
• Use spreads based on a lower cost if buying options that have essentially intrinsic value
• Close positions early to lock in profits from the remaining intrinsic and extrinsic value

Conclusion

Recognizing the differences between intrinsic and extrinsic value can open doors to strategic options trading opportunities. Traders can take advantage of buying undervalued options, selling overvalued options, and deftly handle positions based on these value dynamics. These insights are invaluable for shaping option spreads, choosing expiration, and timing trades. With a proper approach, intrinsic and extrinsic values can generate consistent profits and protect against risks in options trading.