Intrinsic and extrinsic value

An option's premium always splits into two pieces. Separating them is the key to understanding why options gain and lose value the way they do.

Premium = Intrinsic value + Extrinsic value (time value)

Intrinsic value

Intrinsic value is what the option would be worth if exercised right now. It can never be negative.

• Call intrinsic = max(0, Spot - Strike)
• Put intrinsic = max(0, Strike - Spot)

Example: a call with strike 100 while the stock trades at 107 has 7 of intrinsic value. A call with strike 100 while the stock trades at 95 has 0 intrinsic value.

Extrinsic value (time value)

Extrinsic value is everything in the premium above intrinsic value. It is what buyers pay for the possibility that the option moves further into profit before expiry. It is driven mainly by:

• Time remaining — more time, more chance, more value.
• Volatility — a wilder underlying means a bigger chance of a large move, so more value.

A worked split

Stock = 107, call strike 100, premium = 9
  Intrinsic = 107 - 100 = 7
  Extrinsic = 9 - 7      = 2

That 2 of extrinsic value is temporary. As expiry nears it decays toward zero — at expiry an option is worth only its intrinsic value. This decay (theta, covered later) is why simply being "right about direction eventually" can still lose money on an option: time runs out.