What is the intrinsic and extrinsic value of a stock option

In financethe time value TV extrinsic or instrumental value of an option is the premium a rational investor would pay over its current exercise value intrinsic valuebased on the probability it will increase in value before expiry.

For an American option this value is always greater than zero in a fair market, thus an option is always worth more than its current exercise value.

Extrinsic Value and Intrinsic Value | Options Trading — tastytrade blog

As an option can be thought of as 'price insurance' e. Conversely, TV can be thought of as the price an investor is willing to pay for potential upside.

As an option moves closer to expiry, moving its price requires an increasingly larger move in the price of the underlying security. The intrinsic value IV of an option is the value of exercising it now. If the price of the underlying stock is above a call option strike price, the option has a positive monetary value, and is referred to as being in-the-money.

If the underlying stock is priced cheaper than the call option's strike price, the call option is referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder simply abandons the option and it expires worthless. Hence, a purchased option can never have a negative value. For the same reasons, a put option is in-the-money if it allows the purchase of the underlying at a market price below the strike price of the put option.

A put option is out-of-the-money if the underlying's spot price is higher than the strike price.

As shown in the below equations and graph, the Intrinsic Value IV of a call option is positive when the underlying asset's spot price S exceeds the option's strike price K. This price incorporates the expected probability of the option finishing " in-the-money ".

Extrinsic Value by ysygohajavin.web.fc2.com

For an out-of-the-money option, the further in the future the expiration date—i. The sensitivity of the option value to the amount of time to expiry is known as the option's theta. The option value will cisco systems stock market be lower than its IV.

Volatile prices of the underlying instrument can stimulate option demand, enhancing the value. Numerically, this value depends on the time until the expiration date and the volatility of the underlying instrument's price. TV of American option cannot what is the intrinsic and extrinsic value of a stock option negative because the option value is never lower than IVand converges to zero at expiration. Prior to expiration, the change in TV with time is non-linear, being a function of the option price.

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With more time left to expiration, the red curve would be higher; the closer to expiration, the more it would approach the blue intrinsic value line.

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