Importance of Extrinsic Value in Selling Options

Extrinsic premium or risk premium

The definition of Extrinsic Value is the difference between an option’s market price and its intrinsic value. In theory, options should not trade above their Intrinsic Value due to the time value associated with option pricing.
Why is Extrinsic Value important for traders?  We will explain in depth what extrinsic value is. Then we will explain why extrinsic value is necessarily for selling options.

Extrinsic Value

Extrinsic Value is also known as “Time Value” or “Time Premium”. It is the real cost of owning a stock options contract. It is the part of the price of an option which the writer of the option gets to keep as profit should the stock remain stagnant all the way to expiration. As such, extrinsic value is actually compensation to the writer of an option for undertaking the risk of selling an option. Extrinsic value is also the part of the price of an option that decreases as time goes by through a phenomena known as “Time Decay” in options trading.

However, even though the amount of “time” left in a stock options contract is a major determinant of Extrinsic Value, it is NOT only determined by time. Extrinsic value answers the question of “How much money justifies the risk the writer of the option is undertaking”. Out of the money options has much less risk than options who are (almost) in the money.

 

Why Extrinsic Value Is Necessary

Let us look at an example. Let’s assume you own AAPL stocks trading at $100. Why would you write a call option that gives someone else the right to buy those AAPL shares from you, for say $100 (strike price), when you can simply just sell the shares if you want to? What is there to gain? First of all, why would you give anyone any rights to do anything for no compensation at all? This compensation, this fee for the option you are writing, is the extrinsic value.

If AAPL went up in a world without ext. value, the holder of the call option would just exercise his right to buy those shares from you at the strike price and you end up selling your AAPL shares to the holder for no benefit to yourself at all. You allowed someone to buy shares from you whenever that person wants to for nothing in return. If AAPL went down, you lose money on AAPL while the holder of the call option lose nothing since no ext value is paid. In fact, if options had no extrinsic values, everyone would be buying out of the money options for free on every option able stock and profiting from whichever strikes “lottery” by getting in the money. Does that sound even fair to people who writes options?

Yes, option sellers write options for a purpose and that purpose is usually to receive option premium and make a profit from the ext. value that buyers of that option pay. Nothing is free in options trading.

Intrinsic & Extrinsic Value of ITM Call