When trading options, it’s important to understand the difference between intrinsic value and extrinsic value.
And in doing so, it could mean the difference between making money and losing money.
Intrinsic Value
Everybody knows what ‘intrinsic’ means in regular everyday life: real, innate, inherent, of within.
In options, the concept is the same.
The definition of intrinsic value as it pertains to options is: the difference between the underlying stock price and the option’s strike price (that’s in-the-money).
For example: if a stock was trading at $50, and a $45 call option was selling for $6.50, that option would have $5 of intrinsic value.
$50 stock price – $45 call option = $5. If the option premium is worth $6.50, that means $5 of that is intrinsic value.
In this example, that represents 77% of the value. And in general, I like the options I purchase to have at least 60% to 70% of intrinsic value.
The other $1.50 in the example above is extrinsic value, also known as ‘time value’.
Extrinsic Value (aka Time Value)
Extrinsic value is the amount of the premium that’s not comprised of intrinsic value. This part of the premium is said to be your ‘time value’. Out-of-the-money options are comprised of only time value.
Using the same example as above:
A $6.50 premium – $5 intrinsic value = $1.50 of extrinsic value.
So the key to remember is that options are comprised of two parts: intrinsic value and extrinsic value, i.e., time value.
So what’s the difference for the investor?
In the beginning, for all practical purposes, nothing.
If I bought an option at $500 and then sold it for $800, whether half of that was comprised of intrinsic value or none of it was comprised of intrinsic value, it makes no difference from that standpoint.
But ultimately, at expiration, when there’s no time left of the option, your option’s sole value will be its intrinsic value.
So at that point it makes all the difference.
