Option Value: Extrinsic Value and Intrinsic Value

The price of an option can be broken down into two parts: extrinsic value and intrinsic value.

Intrinsic Value

Intrinsic value is the portion of the option that can be realised if the option is exercised. Intrinsic value is the greater of zero and the difference between the exercise price of the option (strike price, K) and the current value of the underlying instrument (spot price, S). If the option does not have positive monetary value, it is referred to as out-the-money. If an option is out-the-money at expiration, its holder will simply “abandon the option” and it will expire worthless. Because the option owner will never choose to lose money by exercising, an option will never have a value less than zero.

For a call option: Instrinsic value = Max [ (S – K), 0 ]
For a put option: Instrinsic value = Max [ (K – S), 0 ]

Extrinsic Value

When an option is trading at more than the intrinsic value, the difference is known as Extrinsic Value, or more commonly known as Time Value.
Time Value = Option Value – Intrinsic Value.

More specifically, an option’s time value captures the possibility, however remote, that the option may increase in value due to volatility in the underlying asset. Numerically, this value depends on the time until the expiration date and the volatility of the underlying instrument’s price. The time value of an option is always positive and declines exponentially with time, reaching zero at the expiration date. At expiration, where the option value is simply its intrinsic value, time value is zero. Prior to expiration, the change in time value with time is non-linear, being a function of the option price.

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