At this point we have covered the basics of options and hopefully you have found our discussions helpful and interesting. From here we will begin to introduce the pricing of options and some new terms we have yet to define. It's at this point that our discussions will become more detailed. We will move into more complex terms, and away from the basics. This will also be the last time we use our fictional example of company XYZ. After today's article we will use real life examples that you can follow in a current market.
Intrinsic and Extrinsic value - In the most basic sense, options are priced with 2 main values in their calculations (in the real world options pricing is quite complex. Pricing will also factor in interest rates, volatility and dividends). Let us begin with intrinsic value. This is the amount that an option is "In the money". Let's pretend that XYZ is currently trading at $31 and you buy the $30 call for $1.65. This call option is "In the money" by $1 (XYZ's price of $31 - The strike we selected $30 = $1). $1 of the premium you paid ($1.65) is called Intrinsic value. As long as XYZ stays at or above $31 your call option will have a value of at least $1.In the real world options almost always trade above their Intrinsic Value. What is this extra premium ($0.65 in our example) that the market is asking you to pay?
Extrinsic or Time Value - Remember that as an option trader you will select the strike price and the expiration date (see our prior articles on the basics of options). The time until expiration is reflected in the pricing of options because there is still the "possibility" of the stock moving higher or lower. In our example, the $0.65 represents the markets assumption that XYZ has the possibility of moving above $31.65 before expiration. Pretend that expiration is in 10 days and that XYZ stays at exactly $31 until then. If this happens the call option will lose value each day as it approaches expiration but will maintain a value of at least $1. The reason for this is that as we get closer to expiration the "possibility" of a large move higher becomes less and less. This is why we say that a buyer of options benefits from a fast and sharp move in the underlying price.
Important note - As an option buyer you will always want to avoid options that are "out of the money" which will have no intrinsic value, and now you know why. In today's example this would mean avoiding buying any calls above $31