These calculations may be very explicit when valuing options at maturity or less so, such as when valuing out-of-the-money options on highly volatile stocks. I have. 2 years.
What is intrinsic value?
The intrinsic value of an option contract is its value if exercised today. Essentially, subtracting the strike price from the current price of the underlying asset gives you the intrinsic value.
For example, stock XYZ is currently trading at $100 and you have a $95 call expiring in 21 days. The intrinsic value looks like this:
100 – 95 = 5
What is extrinsic value?
An option’s extrinsic value goes beyond its intrinsic value. Using the same example as before, XYZ is trading at $100 and owns a $95 call that is currently trading at $8.00.
Calculating the intrinsic value by subtracting the strike price from the original price yields an intrinsic value of $5.00. Now subtract the intrinsic value ($5) from the current option price ($8) to get the extrinsic value of $3.00.
You may wonder why extrinsic values matter. After all, why pay more than intrinsic value? Why not buy the stock outright instead?
Realize that professional options traders are good and quantitative at everything they do. The moment someone thinks an option is too expensive, there are smart and well-funded options traders lining up to sell it at a lower price until the market reaches equilibrium.
Before getting into the conceptual reasons why external value should exist, let’s break down the basic elements of valuing an option contract.
The Black-Scholes model uses the following inputs for option pricing:
- Price of the underlying stock/security
- option strike price
- Time before option expires
- Risk-free interest earned by investing in short-term government bonds
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stock volatility
Underlying asset price and strike price
As you can imagine, the current price of the underlying asset has a large impact on the price of the option. If the underlying trades at $550, you will pay much more for an option exercised at $500 than if it trades at $200.
Ultimately, the relationship between strike price and original price is most important. In general, options traders refer to the “money” in options in his three ways:
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Out of the Money: A call strike is above the underlying price or a put strike is below the underlying price. An option is out-of-the-money (has no intrinsic value) if it would be worthless if exercised today.
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At the Money: This is when the option strike price is the same as the current underlying asset price. For example, if XYZ trades at $100, an ATM strike will result in a $100 put or call.
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In the Money: Calls with a strike below the original price and puts with a strike above the original price are called in the money. For example, a $95 call with an underlying asset of $100 and a $105 put with an underlying asset of $100.
time to expiration
Options are finite securities. They have a definite expiration date after which they are no longer valid. viable. For this reason, much thought has been put into assessing the value of time over the years among options traders and academics.
Common sense suggests that an option that expires 200 days from now should be worth much more than an option that expires tomorrow. The longer the time to maturity, the longer it takes for the stock to move in the direction you expect and the option to be won.
Suppose all options are priced based on intrinsic value. In that case, you can basically “freeroll” by buying options with very long expirations (200+ days) and just wait for the stock to experience upside volatility to sell. It’s free money, which you should definitely know by now, but it’s rarely given in the market.
Volatility of the underlying asset
Volatility, or how much the underlying asset moves each day, has a dramatic impact on option prices. To intuitively understand why this is the case, consider two different invocation options:
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An out-of-the-money call option that expires one year from today for mature companies in low-growth industries such as utilities and tobacco
- Out-of-the-money call options expiring one year from today on growth stocks like Tesla in a new industry
For simplicity, imagine that both underlyings are trading at $100 and each call is approximately 30% out of the money.
Which one do you want to own? Whether or not they want to invest in a company, most will respond with growth stocks. The simple reason is that stocks like Tesla are highly volatile, and the chances of their stocks going up 30% or more over the next year are much higher than those of petty cigarettes or utility stocks.
As a result of this, volatility has a price.
Conclusion
There are good reasons for the existence of extrinsic values. The market is very efficient in pricing options, and by allowing Tesla calls to be purchased for the same value as comparable utility company calls, offering freerolls in the form of free options is not an option. There is none.
To summarize:
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Intrinsic value is the value of an option based on its “monetary quality” if the option were exercised today.
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External value is the value of an option based on all other external factors unrelated to intrinsic value, such as underlying asset volatility and time to maturity.
