Introduction

What is Extrinsic Value? Added to an object's intrinsic value is its extrinsic value. It can be calculated as a sum greater than the asset's market value. The extrinsic worth of something is the total of all values other than the one that the thing itself has (the market value). Value-based on external factors is distinct from value based on internal factors. The price of an asset is based on its intrinsic value or what the asset is worth. An item's extrinsic value is determined by looking at factors beyond its internal properties, such as size and physical appearance.

Extrinsic Value Example

So, if the Spot price of the underlying option is 100 or less, and the call option's exercise price is $100, then the payoff will be $0. If the Spot price is $110 at the end of the option's term, the payout would be ($11.00 * 110 - $100.00). Assuming three months have passed since expiration, we estimate that the underlying is worth $120. As a result, the cost of the option will increase beyond the current payout of $10 (to as much as $15). If volatility stays the same, the extra $5 is due in part to an external value, specifically the time value.

Basics of Extrinsic Value

The price or value of an option is made up of two parts: the intrinsic value and the extrinsic value. To calculate the intrinsic value, subtract the option's strike price from the market price of the underlying security at the time of the cash settlement. When a call option is meaningful when the underlying security price is less than the strike price, the premium for the option is determined solely by the option's intrinsic value. The value of a put option is based solely on its intrinsic worth when the underlying security is trading at a price above the strike price at which the option was purchased.

Features

• An options writer will sell options to profit from the decay of the options' time value or extrinsic value.
• Things made of metal are more likely to be stolen than others because of their value as raw materials or commodities.
• A thing's extrinsic value is whatever society assigns to it, not something inherent in the thing itself.
• Contrast this with the value placed on something for what it can do for you (its instrumental value or extrinsic value), and you'll see what we mean.

How Does Extrinsic Value Work?

An asset or product's extrinsic value, defined as its value apart from its intrinsic value, is an important factor in pricing decisions. An option's extrinsic value is calculated by subtracting its intrinsic value from the value of the underlying security or asset. On the other hand, the intrinsic value is calculated by subtracting the strike price of an option from the security's current market price.

Factors Affecting Extrinsic Value

Generally, factors unrelated to the security will be used to establish its "intrinsic value." Both time and implied volatility (or market volatility) play significant roles in determining the asset's value. Analysts and traders often refer to the extrinsic value as Time Value. The primary factor in determining the extrinsic value of a security or asset is the passage of time, as the degree to which the value of an option increases or decreases is based on the length of time the security or asset is used in the market.

1. Length of the Contract

The duration of a contract is a major factor in determining its extrinsic value. Since it takes less time for security to shift in favor of the owner, the value of a contract decreases as its expiration date approaches. Due to this, it makes sense for the owner to pay a higher intrinsic value for options that have a long time until expiration.

2. Implied Volatility

A measure of the potential degree of price fluctuation over a specified period is an asset's implied volatility (or vega). The value of time plus volatility yields the option's intrinsic value.

Conclusion

The difference between the strike price and the underlying asset price is an option's intrinsic value, while its market value, also known as its price, is the difference between the two. As market uncertainty grows, so does the value of extrinsic factors. The intrinsic value of an option is calculated by subtracting its market value (also known as "the price") from its intrinsic value, which is the value of the option contract relative to its underlying asset at the time of expiration or exercise. An agreement's worth typically drops as its expiration date approaches because there is less time left for security to shift in the owner's favor. The intrinsic value of the options goes up if the security's volatility increases, and the opposite is also true.