How Options are priced: Intrinsic value and Extrinsic value

In the world of options trading, understanding how the price of an options contract is determined is crucial. It’s not just a random number; it’s a result of various factors that come into play. The option premium (the amount of money paid for the option), depends on elements such as the underlying security’s price, the option’s strike price, time until expiration, volatility of the underlying asset, current risk-free interest rate, and the dividend rate of the underlying security.

Intrinsic value:

The intrinsic value of an options contract is the value of the option at expiration. Imagine if the contract were to expire immediately; the remaining value would be its intrinsic value. Calculating this intrinsic value involves finding the difference between the current price of the underlying security and the option contract’s strike price. If this difference is positive, the option is considered “in-the-money.” For call options, intrinsic value is how much the current price exceeds the strike price, while for put options, it’s the amount the current price falls below the strike price.

However, it’s essential to note that an option’s overall value typically surpasses its intrinsic value due to external factors such as time until expiration and market volatility, constituting what is known as extrinsic value.

In-the-money (ITM): Options contracts that are in-the-money (ITM) are those with a positive intrinsic value. For instance, a call option is considered in-the-money if the current price of the underlying security exceeds the option contract’s strike price.

As an example, a call option with a Rs.250 strike price is in-the-money when the underlying security’s current price is above Rs.250.

At-the-money (ATM): At-the-money (ATM) options contracts occur when the option’s strike price matches the current price of the underlying security.

For example, a call option with a Rs.250 strike price is at-the-money if the underlying security’s current price is Rs.250. These contracts hold the highest extrinsic or time value due to their potential for changes in intrinsic value.

Out-of-the-money (OTM): Out-of-the-money (OTM) options contracts lack intrinsic value because they are not profitable based on the current price of the underlying security and the contract’s strike price. In the case of an out-of-the-money call option, the underlying price is lower than the option’s strike price. Exercising an out-of-the-money options contract does not yield a positive payoff.

For example, a call option with a Rs.250 strike price is out-of-the-money if the underlying security’s current price is below Rs.250.

Extrinsic value:

The value of an options contract over and beyond its intrinsic value is known as extrinsic value.The extrinsic value of an options contract is also called the time value because the remaining value is depends on external factors like the amount of time left on the contract, the volatility of the underlying security, the current risk-free interest rate, and the dividend rate of the underlying security.

The extrinsic value elements have minimal effect on the option price if the price of the underlying securities is much above or below the contract’s strike price.

As extrinsic value is the cost of the chance to profit from future price movements of the underlying security, it can be considered as the actual cost of an options contract.

Extrinsic Value (Time value)=Option Premium−Intrinsic value

Volatility

Volatility in options is about how much the price of the thing you’re trading goes up and down. If the price moves a lot, we say it has high volatility; if it stays pretty steady, it has low volatility. This matters for options because it’s one of the main things deciding their price. Along with intrinsic value and how much time is left, volatility helps set the cost of an option. Simply put, if the thing you’re trading is all over the place, the option will cost more. More ups and downs mean a bigger range of possible outcomes for the option.

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Key Takeaways:

• Intrinsic value is the true worth of an option at expiration, determined by the difference between the current and strike prices.
• Extrinsic value, or time value, represents the cost of profiting from future price movements and is influenced by factors like time, volatility, and interest rates.

*** Disclaimer: The information provided in this article is for educational purposes only. It is not intended as financial advice, and readers are encouraged to seek professional guidance before making any investment decisions.