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The value of an option

Lesson in Course: Derivatives and options (beginner, 5min)

I've learned that options contracts represent a promise to buy or sell shares at a fixed price between two investors. What makes the promise valuable?

Eureka!

What it's about: The value for an option is split between two very different forms. 

Why it's important: Depending on the option we buy or sell, the value will change forms over time.

Key takeaway: Intrinsic value is dependent on a difference in price. Extrinsic value is dependent on a difference in time.

When was the last time we've seen a promotional offer? 

How to Get Free Uber Eats Food — Plus Free Delivery - The Krazy Coupon Lady

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 promise

Intrinsic value is based on the prices negotiated in a contract

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.

What is Intrinsic value?

A contract's intrinsic value is the value received today by the holder of the contract if both parties fulfill their obligation.

For an option, this value is the amount an option holder would receive if they were to exercise an option and close out the position at the current market price.

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. 

Mark your calendar: Free Chick-fil-A Nuggets this January | Chick-fil-A

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.

What is Extrinsic value?

The extrinsic value of an option is the additional value beyond the intrinsic value that an investor is willing to pay for an option's price. 

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.

Option price = Intrinsic + Extrinsic value
Intrinsic & Extrinsic Value Explained (Options Trading) | projectoption

We can see that in the graph above, our options contract starts with a price of $17 per share. Let's assume we purchase it right away. Out of the $17, the majority of the value, $12, is actually in extrinsic value (the red shading) compared to the intrinsic value of $5. As our contract gets closer to maturity, the trend is for our extrinsic value to shrink. We can see this with the area in red becoming smaller on the right side of the graph. We'll learn more about this observation in future lessons.

 

Actionable ideas

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?

Glossary

What is Intrinsic value?

A contract's intrinsic value is the amount an option holder would receive if they were to exercise an option and close out the position at the current market price.

For example, if $F is trading at $10 a share, then a call option at the strike price of $9 a share has $1 per share in intrinsic value. We can buy $F at $9 and turn around and sell it in the market for $10 for a gain of $1.

What is Extrinsic value?

The extrinsic value of an option is the additional value beyond the intrinsic value that an investor is willing to pay for an option's price. 

It represents the time value and captures the possibility that the underlying may further increase or decrease in value.