Option Premium: Intrinsic vs Extrinsic Value

Premium = intrinsic value + extrinsic value.

Three words first. In the money: the option would be worth something if it expired right now. At the money: the strike sits right at the underlying's price. Out of the money: it would be worth nothing if it expired right now.

• Intrinsic value. The real money in the option right now: how far it is in the money. For a call, the underlying's price minus the strike. For a put, the strike minus the underlying's price. Never below zero, because you would simply not exercise.
• Extrinsic value. Everything above intrinsic. It is what you pay for time left and for expected movement: the price of the fact that the outcome is not decided yet. At expiry it is gone, and only intrinsic remains.

Example: a 6,000 call trading at 95 with the index at 6,080. The call is 80 in the money, so 80 is intrinsic and 15 is extrinsic. You pay 80 for money that already exists and 15 for the chance that more of it shows up.

Fact marks Black-Scholes maths, true by definition. Naive model marks a story about what price or dealers will do: useful, not a fact.

A 100 strike, small round numbers so the arithmetic is easy to check. The coral band is intrinsic, the teal band on top is extrinsic. Move the underlying, then drag the days to zero and watch the teal band vanish. Implied vol is the market's estimate of how much the underlying will move; more on it below.

FactHold everything else still and move one driver at a time. Each one changes how much of the outcome is still undecided.

• Moneyness. Near the strike the outcome is most undecided, so extrinsic is fattest there. Deep in the money it is nearly settled, far out of the money it is probably worthless: little to pay for either way.
• Time. More days left means more chance for price to travel somewhere useful. A one-year policy costs more than a one-week policy on the same house.
• Implied volatility. The market's estimate of how much the underlying will move. Fire insurance on an igloo is cheap. On a wooden house on a hot dry day with a barbecue going, it is expensive. Same cover, same payout, same twelve months. When people say "vol is up", the barbecue got lit.

Four quotes. Split each premium into intrinsic and extrinsic.

When I hear that vol is up, I read it as the market pricing a wider range of outcomes. Options got more expensive without the underlying doing anything at all. Nothing about the positions changed. The price of risk did.

Naive modelAnd when an options level far from price stops reacting later in the day, I remember what the extrinsic is: the price of outcomes still open. As the day's expected move shrinks, a far strike drifts out of reach. The position can still be open on the board while the force behind it has drained away.

Knowing what an option price is made of is one piece of reading the market. The Mentorship is where you put the whole process together.