The price of an option consists of its intrinsic and extrinsic values and while the intrinsic value of underlyings act the same, extrinsic values do not, which we will explain.
The intrinsic value of an option is its value in relation to the underlying at expiration or if exercised. The simple calculation of intrinsic value for calls is the price of the underlying minus the strike price. Extrinsic value is the price of the option minus its intrinsic value.
A way to look at extrinsic value is as the “risk premium” of the option. The option writer takes on undefined risk and the buyer is paying a premium for having a position with limited risk with unlimited profit. It’s obvious that some stocks are more volatile and therefore riskier than others. The higher option prices are, the more risky the stock is perceived to be. Higher option prices lead to higher levels of implied volatility (IV).
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the takeaways and a better understanding of intrinsic and extrinsic value.
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