Intrinsic and Extrinsic Value

Intrinsic Value
Intrinsic value is the relationship of the price of an underlying security along with the strike price of the option. As we know these are referred to as out of the money OTM, at the money, ATM, and in the money ITM. Intrinsic value lets us know if an option actually has any real or true value to it. Only ITM options, no matter if they ITM calls or ITM puts, are able to have intrinsic value to them. For instance, let us say that RIP is at $27 per share. The ITM $25 call is trading for a premium of $3, however it only has $2 of intrinsic value. How does this work exactly? All that has to be done is to subtract the call strike from the actual price of the stock, in other words: $27 minus $25 equals $2. The $25 call consists of $2 of intrinsic value and $1 of extrinsic value. The exact same would be done for a $30 ITM put option that is for instance trading at $4 with RIP at $27. This would mean that there is a $3 of intrinsic value, in other words, $30 minus $27 equals $3.

Extrinsic value
What does extrinsic value consist of? Extrinsic value is the remainder of what has been subtracted from the intrinsic value. Intrinsic value will allow a person to know if an option is really worth it at the moment in time. Let’s imagine that we own the RIP $25 call and want to exercise it. What is the following step? We are able to purchase one hundred shares of RIP for $25 per share, and this is a couple dollars cheaper than what it is trading for in the market. If we were interested in doing so, we would have the alternative to sell the one hundred shares right away and obtain a gain of $2 for every share. This is precisely what intrinsic value is. ATM and OTM options however, do not have absolutely any intrinsic value. They are made up completely of extrinsic value. This is because if we were to try to use an ATM or OTM option, we would end up losing our money. Once again imagine that RIP is at $27. The nearest ATM call would be the $27,50 call option and the nearly OTM Call would be the $30 call option. If either one of these were utilized the one hundred shares would have to be purchased at either $27.50 or $30 for every share. Nobody would be interested in doing such if RIP is trading at $27 in the market for example. Therefore ATM or OTM options do not have any real or intrinsic value.