Options Trading Guide

Options Trading: Understanding the Intrinsic and Extrinsic Value


A trade option's premium is composed of two elements- there is the intrinsic value and the extrinsic value.


Understanding Intrinsic Value

The intrinsic value is comparable to equity in a home. It can be defined as the percentage of the premium's value that is driven by the stock price overall.


Let us use a concrete example to illustrate the point. You own a call option on a stock that is presently trading at $47 per share. To make this simple to understand let's say that you own a call with a strike price of $45. The option premium for it is $3. Due to the fact that the stock happens to be $2 more than the price of the strike that means that $2 of the $3 premium is known as intrinsic value (or equity as it was described previously), while the $1 that is left is extrinsic value. In order to determine how much the stock must move for more profit to be seen you can add the premium price to the price of the strike. It would look like this: 3 + 45 = 48.If you want to learn more on how to choose the right options trading software, you can visit http://www.mahalo.com/category/software.


Extrinsic value is often referred to as the time-value component of the option price. It is the additional cost that is paid out for the privilege of owning the option that is above and beyond what its intrinsic value is worth. Options that have intrinsic value are described as being "in the money" (ITM) while those that have no intrinsic value but lots of extrinsic value are described as being "out of the money" (OTM). Options that have plenty of extrinsic value tend to be less sensitive when it comes to the movement of stock prices. Options with plenty of intrinsic value are more in balance with the price of a stock. The name given to the sensitivity of an option in terms of the underlying movement of the stock is known as delta.  Know how to trade options here!


Understanding Extrinsic Value

Extrinsic value is sometimes referred to as time value. It is important to note however that this is somewhat of a misnomer. Extrinsic value is made up of implied volatility that fluctuates in so much as the demand for options fluctuates. However other influences affect it including stock dividend changes and interest rate shifts. Time value and implied volatility tend to be greatest influences than interest rates and dividends.


The above is an overview of intrinsic and extrinsic value in options trading software.