Option contracts pricing consists of both the extrinsic value and intrinsic value that combine to create what each strike price and expiration is worth in an option chain. Extrinsic value is the potential of what an option has to be worth in the future while the intrinsic value is how much an option is worth now.
What is Extrinsic Value?
Extrinsic value is the time value and implied volatility risk premium priced into an option contract. It consists of everything that isn’t considered intrinsic value. The extrinsic value of an option contract changes based on it’s moneyness and the underlier’s implied volatility.
Intrinsic vs Extrinsic Value
Intrinsic value is always the known current value of an option based on it already being in-the-money while extrinsic value is the total option premium of theta and vega less intrinsic value. An out-of-the money option can be all extrinsic value while a deep in-the-money option near expiration can be almost all intrinsic value.
Extrinsic value consists of the value of the probability that an option contract will expire in-the-money based on time remaining and the velocity of movement. Extrinsic value increases with volatility and an option getting closer to being in-the-money while intrinsic value increases as an option goes deeper in-the-money.
Remaining Time Value + Volatility Pricing = Extrinsic Value
Extrinsic Value + Intrinsic Value = Total Option Value
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