Learn Option Pricing: Understanding Intrinsic and Extrinsic Value in Options Trading 101
Welcome to the second installment in our Learn Options Series, a professional and accessible guide designed to enhance your stock options education. In this article, we dive into one of the most essential components of options trading: how options are priced. Mastering this topic is crucial for learning options effectively and making smart trading decisions.
Why Option Pricing Matters
Understanding option pricing is foundational in your options trading journey. It impacts your profit potential, risk exposure, and trade selection. Whether you’re buying or selling options, knowing what influences option prices helps you avoid overpaying and allows you to seize high-probability opportunities.
Components of Option Value
An option’s price, also known as the premium, consists of two main parts:
1. Intrinsic Value
This is the real, tangible value of the option. It reflects how much the option is currently “in the money.”
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Call Option: Intrinsic value = Stock price – Strike price (if stock price is higher)
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Put Option: Intrinsic value = Strike price – Stock price (if stock price is lower)
Example:
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Stock ABC = $55
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Call Option Strike = $50
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Intrinsic Value = $55 – $50 = $5
2. Extrinsic Value (Time Value)
This is the speculative portion of the option’s premium. It reflects:
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Time remaining until expiration
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Expected volatility (Implied Volatility or IV)
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Supply and demand
Formula:
Premium = Intrinsic Value + Extrinsic Value
If a call option with a $5 intrinsic value trades at $7, the extrinsic value is $2.
Time Decay (Theta) and Extrinsic Value
Time decay—also called Theta decay—reduces an option’s extrinsic value over time. The closer an option is to expiration, the faster its value decays, especially if it’s out of the money.
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Short-term options lose value faster.
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Longer-term options retain more time value but are more expensive.
Example:
You buy a call option on XYZ for $3, expiring in 30 days. If the stock doesn’t move, your option may lose $0.10–$0.15 in value per day as time decay sets in.
The Role of Implied Volatility (IV)
Implied Volatility estimates how much the market thinks the stock could move. Higher IV increases the extrinsic portion of the premium.
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High IV = Expensive options
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Low IV = Cheaper options
Example:
Two identical options:
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Option A: IV = 20%, premium = $2.00
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Option B: IV = 40%, premium = $3.50
Even though both options have the same strike and expiration, Option B is more expensive due to higher IV.
At the Money (ATM), In the Money (ITM), and Out of the Money (OTM)
Option moneyness affects pricing:
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ATM: Strike ≈ Stock price → Highest time value, no intrinsic value
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ITM: Strike is favorable → Has intrinsic + time value
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OTM: Strike is unfavorable → Only time value
Example:
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Stock DEF = $100
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$100 Call: ATM
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$90 Call: ITM
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$110 Call: OTM
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How Traders Use Option Pricing to Make Better Decisions
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Buy ITM calls/puts for directional conviction (more expensive but less decay)
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Sell OTM options to collect premiums with lower probability of being exercised
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Avoid overpaying during high volatility unless expecting large moves
Quick Tips for Learning Options Pricing
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Compare similar strikes across expiration dates
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Monitor implied volatility charts
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Use pricing models like Black-Scholes for theoretical value
Wrapping Up Your Options Pricing Education
Learning how options are priced is a key part of your stock options education
