When was the last time we've seen a promotional offer?
All promotional offers allow us to save or earn $X within a period of time and once the promotion expires, the value promised is gone. Options contracts are similar to promotional offers since options contracts always have an expiration date. Investors and traders have understood the temporal difference between options and stocks and have placed additional value on the time within an option contract. Let's step through the additions to an option's value.
The bulk of an option's value is tied to the promise of the contract. For the owner of a call option, it's the promise to be able to buy 100 shares of a stock at the strike price. For the owner of a put option, that promise is to be able to sell 100 shares of a stock at the strike price. If we revisit the Uber Eats coupon example above, we can see that the coupon is a very simple call option. As the owner or holder of the coupon, we are able to buy $60 worth of food for a fixed cost of $35. This contract has $25 in monetary or intrinsic value to us if we choose to use it.
The intrinsic value is determined by the relationship between the promised price (strike price) and the actual price of the underlying stock. As we learn more about options, we'll see how to calculate the intrinsic value using the strike price.
Can the intrinsic value ever be negative?
No, the intrinsic value of an option can never be negative because the buyer of a stock option is not required to go through with a bad deal. Let's revisit the example above and assume the coupon is only good for $25 worth of food while still costing us $35 to use. With the current deal, we would lose money if we tried to use the coupon. By simply choosing not to use the coupon, we avoid potential losses.
Time is money
Apart from the change in price, there's also the value in the time of the offer itself. Let's imagine a Chick-fil-A opened up near us and we are waiting for it to appear on Uber Eats.
A promotional offer from Uber Eats for 10 days has less of a chance to help us get a discount for chicken nuggets than a promotional offer for 120 days. To us, the 120-day offer is a better one even though both provide the same $25 discount. Would we be even tempted to want to pay $5 to extend the 10-day promotion to a 120-day discount? I bet we know some folks who would and this value is called the extrinsic value.
Extrinsic value is calculated based on many different external factors with the most prominent factor being maturity or the length of time the contract is valid. We won't cover all of the external factors yet. Instead, let's step through an example to get a basic understanding of intrinsic and extrinsic value.
A simple trick to remember the intrinsic value and extrinsic value is through using these statements, "I promise to" and "time is extra." Intrinsic is the promise and it starts with "I." The extra value of time is extrinsic. Clearly understanding the difference between the two values will keep us informed on choosing which options are right for us. Do we value the current promise more? Or do we value what could be?