Extrinsic Value of an Option

This is what makes stock options so risky...

The extrinsic value of an option is the dollar value that is placed on the remaining life of the option.

Similar to how the life insurance industry attaches a dollar figure to the estimated remaining years of your life. This dollar figure is what they use to create your insurance "premium".

It's slightly more complicated than that, but I think you get the point.

Well the time left until a stock option expires is given a dollar value and this is placed into the "premium" (cost) of the option along with the 5 other factors that we discussed in Lesson 1.

Extrinsic Value is also called time value. You will hear both terms used.

Extrinsic Value and its Effect
on Option Pricing

Simply put, here is the effect that time value has on option price: generally, the longer the time until expiration, the greater the cost of the option. An option with more days left until expiration will cost more than an option with fewer days left until expiration.

An option with three months left until expiration has more time than an option that expires in two weeks.

There is a greater chance the stock will move significantly over the span of three months then it will in two weeks.

***So you're essentially paying for that time.***

Below is a snapshot of an option chain showing you how the cost of the option increases the further out in "time" (expiration month) you go:

The picture is of an IBM 95 Call Option. The strike price is $95. The arrows point to the cost of the February 95, March 95, April 95, and July 95 Call option.

What Happens if the Stock
Doesn't Move?

Suppose you buy an option with 3 months left until expiration. You have paid for 3 months worth of time.

If the stock doesn't move for a month and stays at the same price, then the value of your option will be worth less then when you bought it (it will decrease in value).

This is because the time value (extrinsic value) has been ticking away.

You now have only two months of value left in the options price. This is called: time decay.

This is also why options are often called wasting assets, and is part of what makes them risky.

With stocks you can hold onto them forever waiting for them to move in the desired direction. With options, the moment you buy them the clock starts ticking away. The stock "must" move, or you will start losing money.

As a trader you have to be disciplined and thorough in your research. You want to pick the best stocks poised to make a move in a relatively short period of time.

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