How Intrinsic and Extrinsic Value Shape an Option’s Premium
Summary
The document explains an option’s price as intrinsic value plus extrinsic value. Intrinsic value measures how far an option is in the money: for a call, it is the underlying price minus the strike; for a put, it is the strike minus the underlying price. Out-of-the-money options have no intrinsic value. Extrinsic value is the option price remaining after intrinsic value is subtracted.
It describes time to expiry and implied volatility as key influences on extrinsic value, alongside rates, dividends, and the distance between strike and underlying price. Using illustrative charts for a fictional asset, it states that longer time to expiry and higher implied volatility generally increase extrinsic value, while at-the-money options have the most extrinsic value, which declines as the underlying moves away from the strike. The examples are explanatory rather than market evidence, and the discussion simplifies pricing by noting that the platform sets interest and dividend inputs to zero for crypto markets. It does not cover detailed model assumptions or practical effects such as fees and bid-ask spreads.
Key ideas
- An option’s value consists of intrinsic value and extrinsic value.
- Call intrinsic value is the positive difference between the underlying price and strike; put intrinsic value reverses that relationship.
- Extrinsic value is the option premium after intrinsic value is removed.
- More time to expiry and higher implied volatility generally raise extrinsic value, all else equal.
- At-the-money options have the greatest extrinsic value in the examples presented.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.