Alert

Cardano, the sixth largest crypto asset by market cap, is now available to trade on tastyworks. Here’s what you should know.
tastytrade

Understanding Extrinsic Value

Dec 8, 2016

By: Sage Anderson

When trading volatility it’s easy to become preoccupied with the VIX, market trends, and news flow. While these are critical components of effective analysis, we can’t forget the basic building blocks of options trading.

According to the infamous Black-Scholes model, there are two important values that together represent the market value of an option - intrinsic and extrinsic value.

The intrinsic value of an in-the-money (ITM) option is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero. For example, the $15 strike call of a stock trading $20 will have an intrinsic value of $5 ($20-$15 = $5). And the $25 strike call of a stock trading $20 will have an intrinsic value of $0 (at expiration).

Extrinsic is the term used for the value of an option beyond its intrinsic value. Demand in the market dictates the “premium” that traders are willing to pay - which dictates extrinsic value. Going back to the previous example, a $25 strike call trading for $0.25 with stock trading $20 and one hour until expiration will have an extrinsic value of $0.25 (because there is no intrinsic value left in this option).

Similarly, a $15 strike call worth $6 with the stock trading $20 and two weeks until expiration will have an intrinsic value of $5 and an extrinsic value of $1.

Extrinsic value is implied by the market because of the 5 inputs used to calculate the price of an option using the Black-Scholes model, the extrinsic value (implied volatility) is the only unknown. Plugging the four known factors into the equation therefore allows us to solve for the unknown.

This is the primary reason that the fair market value when trading is referred to as “implied volatility.”

A recent episode of Best Practices takes a close look at “extrinsic value” and provides a 360-degree perspective on the topic.

As noted in the episode, extrinsic value rises and falls based on demand for protection in the marketplace - option prices get more expensive (i.e. extrinsic values go up) when “fear” increases.

The generally inverse relationship between the S&P 500 and the VIX provides reinforcement of this pattern – when the S&P 500 is falling (fear is rising), the VIX tends to increase.

As you can see in the next graphic (shown below), the extrinsic value of the at-the-money (ATM) straddle in Apple (AAPL) was much higher when the market was dropping, as compared to now:

Taking these learnings a step further, it shouldn’t be surprising to learn that implied volatility will generally be higher for the options of high-flying stocks as compared to Blue Chips.

The chart below provides stark evidence of this phenomenon by comparing the implied volatilities of Coca-Cola (KO), General Electric (GE), Apple (AAPL), and Tesla (TSLA):

Going out in time, extrinsic value generally increases due to the vega component of the options price. Obviously, the further one goes out in time, the more difficult it is to forecast a stock’s price – thus the added premium found in extrinsic value.

While the VIX and Implied Volatility Rank (IVR) can help guide overall portfolio structure, extrinsic value is another factor that can be evaluated when deploying and managing a volatility-based strategy.

If you have any questions about extrinsic value we hope you’ll reach out at support@tastytrade.com.

Thanks for reading!


Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.


Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Related Posts

tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.

tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.

Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.

Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.

© copyright 2013 – 2021 tastytrade. All Rights Reserved. Applicable portions of the Terms of use on tastytrade.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastytrade’s podcasts as necessary to view for personal use.