If you are to going to be successful trading options, it's imperative that you understand how they are priced. Specifically, you should know the difference between the intrinsic value and extrinsic value. These are the two main components that make up the price of an option, and they are fundamentally important to virtually every trading strategy you may use.
You should also know that all options contracts traded on the exchanges are listed with a bid price and an ask price, and you should recognize the significance of this.
On this page, we explain all the relevant aspects of how options are priced.
In very simple terms intrinsic value is the real, tangible value of an options contract. It's sometimes referred to as fundamental value and it's basically the amount of profit, if any, that is built into an options contract at a specific point.
Intrinsic value is closely related to options moneyness, which is a very important concept. Options moneyness is essentially the relationship between the strike price of an option and the current price of the underlying asset, and defines whether an options contract is in the money, at the money, or out of the money. This is largely determined by the intrinsic value.
When the price of the underlying asset of an option is favorable to the holder in relation to the strike price of the contract, there is intrinsic value in that option. For example, imagine you have a call option based on stock in Company X with a strike price of $20, while Company X stock is actually trading at $25. The options has intrinsic value of $5, as you could theoretically make $5 profit by exercising your option to buy the stock at $20 and then sell it at $25. If Company X stock was trading at $30, then the intrinsic value would be $10.
Similarly, imagine a put option based on stock in Company Y with a strike price of $50, while Company Y stock is actually trading at $48. The intrinsic value here is $2, as you could theoretically make $2 profit by buying the stock at $48 and then exercising your option to sell it at $50. When there's intrinsic value in an option, it's said to be in the money.
It's possible, of course, for an options contract to have no intrinsic value. If a call option has a strike price that is higher than the current price of the underlying security, then there would be no profit to be made from exercising the option at that point and because of this there is no intrinsic value.
The same would be true for a put option that had a strike price lower than the current price of the underlying security. In such circumstances, the contract is said to be out of the money. When the strike price of an options contract is equal to the price of the underlying security, the contract is said to be at the money.
Calculating intrinsic value is really quite simple. For call options, you subtract the strike price from the current price of the underlying security. For put options, you subtract the current price of the underlying security from the strike price. Intrinsic value cannot be a negative number though. If there is no intrinsic value, then the intrinsic value is considered to be zero. All in the money contracts have intrinsic value, while at the money contracts and out of the money contracts do not.
The extrinsic value of an options contract is the less tangible part of the price. It's determined by factors other than the price of the underlying security and can also be known as premium value or time value. It's essentially the part of the price that accounts for the risk being taken by the writer of the option. Extrinsic value is basically the true cost of owning an option, because any intrinsic value that you pay for is already reflected in the current theoretical profit of the contract.
The reason extrinsic value is sometimes known as time value is because one of the main factors which affect the extrinsic value of an options contract is the time left until it expires. Generally speaking, the extrinsic value will be higher when there is more time left. As a contract moves toward the expiration date, the extrinsic value will typically decrease due to time decay, and there's less time for the price of the underlying security to move. Time value isn't a particularly accurate label for extrinsic value though, because there are more factors involved than just the time element.
To truly understand extrinsic value, you need to understand how pricing models, such as the Black Scholes Model, work and aid in Options Trading. However, when you are just getting started with options trading, it's sufficient to understand just the basic principles. Mainly the fact that it represents the true cost of owning an option and serves as compensation to the writer of the contract for the risk they are taking.
Accurately calculating extrinsic value can be quite complicated, and again you really need to understand options pricing models, but there is actually a relatively simple way to work out how much you are paying in extrinsic value for any options contract you buy.
As we have mentioned above, any options contracts that are either at the money or out of the money have no intrinsic value. Therefore, the price of any at the money option or out of the money is made up entirely of extrinsic value. For an in the money contract, the extrinsic value can be determined simply by deducting the intrinsic value from the price. For example, if an in the money option is selling for $3 and it has an intrinsic value of $1, then the extrinsic value option must be $2.
Quite simply, providing you know the price of an option and can calculate the intrinsic value, then it's easy enough to also calculate the extrinsic value.
Bid Price & Ask Price
The bid price and the ask price of options aren't affected by how actual prices are determined, but rather by how options are bought and sold on the exchanges. Whenever you see the price of options quoted on the exchanges, you will see two prices listed: the bid price and the ask price. You really need to understand the difference between these prices and why this difference exists.
The bid price for any particular contract is the price at which you can sell, or write, those contracts for. The ask price is the price at which you can buy those contracts, and will always be higher than the bid price at any given point in time. The difference between the bid price and the ask price is the bid ask spread, this is the built in margin that helps determine the cost of options.
It's important that you are aware of this, because this margin is effectively a cost of trading. If you are actively trading and buying and selling contracts on a regular basis, then the bid ask spread can have a significant impact on your profits. For example, if you buy contracts with the intention of selling as soon as there is a small increase in the price, that increase must be bigger than the size of the bid ask spread if you want to make a return.
The main reason that the bid ask spread exists is to attract market makers into the marketplace. Market makers basically exist to ensure that there is enough liquidity in the market for traders to buy and sell the options they wish to trade. If there isn't enough buyers and sellers, then the market can stagnate and it's difficult to execute your chosen transactions.
Market makers resolve this problem by effectively stepping in to facilitate a trade when one party wishes to buy or sell, but there's no other party willing to fill the other side of the transaction. In return for keeping the market moving, market makers are able to buy at the bid price and sell at the ask price, thus making a small margin on every trade they make.
Most quotes also contain another price:the last price. This is the last price that a particular contract was traded at. With certain financial instruments, the last price is particularly significant, but it isn't hugely relevant when trading options. This is due to the fact that the price of options can change without there being a transaction. One example of this would be when the price of the underlying security moves dramatically.