Option Premium = Intrinsic Value + Extrinsic Value
The option premium (the price you pay or receive for an option) can be split into two parts:
- Intrinsic value: the amount the option is in-the-money right now.
- Extrinsic value (also called time value): everything else in the premium—value tied to time remaining, volatility, and other inputs.
A simple way to remember it:
Premium = Intrinsic + ExtrinsicIntrinsic is determined by the stock price relative to the strike. Extrinsic is the “extra” the market is willing to pay beyond intrinsic because the stock could move further before expiration.
Intrinsic Value Formulas
Let S = stock price and K = strike price.
- Call intrinsic =
max(S − K, 0) - Put intrinsic =
max(K − S, 0)
Then:
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Extrinsic = Premium − IntrinsicMoneyness: ITM, ATM, OTM (Calls vs Puts)
Moneyness describes whether exercising the option right now would have value.
| Type | In-the-money (ITM) | At-the-money (ATM) | Out-of-the-money (OTM) |
|---|---|---|---|
| Call | S > K | S ≈ K | S < K |
| Put | S < K | S ≈ K | S > K |
ATM is not a single exact point in real markets; it usually means the strike closest to the current stock price.
Numeric Examples: Splitting Premium into Intrinsic and Extrinsic
In the examples below, assume each option contract represents 100 shares. Premiums are shown per share (so multiply by 100 for the contract cost).
Example Set A: Call Option with Strike 50
Assume a call with K = 50. We’ll look at different stock prices and different premiums to practice the split.
| Stock (S) | Call Premium | Moneyness | Intrinsic | Extrinsic |
|---|---|---|---|---|
| 45 | 1.20 | OTM | max(45−50,0)=0 | 1.20−0=1.20 |
| 50 | 2.10 | ATM | max(50−50,0)=0 | 2.10−0=2.10 |
| 55 | 6.80 | ITM | max(55−50,0)=5.00 | 6.80−5.00=1.80 |
Key observation: once a call is ITM, it has intrinsic value, but it can still have extrinsic value on top of that.
Example Set B: Put Option with Strike 50
Now assume a put with K = 50.
| Stock (S) | Put Premium | Moneyness | Intrinsic | Extrinsic |
|---|---|---|---|---|
| 55 | 1.10 | OTM | max(50−55,0)=0 | 1.10−0=1.10 |
| 50 | 2.40 | ATM | max(50−50,0)=0 | 2.40−0=2.40 |
| 45 | 6.30 | ITM | max(50−45,0)=5.00 | 6.30−5.00=1.30 |
Key observation: puts become ITM when the stock is below the strike, and the intrinsic value grows as the stock falls further below the strike.
Step-by-Step Method You Can Use Every Time
- Identify option type (call or put).
- Compute intrinsic using the correct formula.
- Compute extrinsic as
premium − intrinsic. - Classify moneyness: ITM if intrinsic > 0, ATM if near 0 at the closest strike, OTM if intrinsic = 0 and not ATM.
Time Value and Time Decay (Theta)
Extrinsic value is often called time value because one major reason it exists is time remaining. With more time left, there’s more opportunity for the stock to move favorably, so buyers are typically willing to pay more extrinsic value.
Theta is the Greek that measures how much an option’s price tends to change as time passes, holding other factors constant. For many long options (options you buy), theta is typically negative: as time passes, the option tends to lose extrinsic value.
Time Decay Is Generally Not Linear
A common beginner mistake is to assume an option loses the same amount of value each day. In practice, time decay often accelerates as expiration approaches, especially for options near the money.
Conceptually, you can think of extrinsic value as “melting” faster near the end. This is one reason short-dated options can feel unforgiving: you can be directionally correct but too early, and time decay can still hurt the premium.
Illustrative (Simplified) Time-Decay Example
Suppose a stock is at 50 and you’re looking at the 50-strike call (ATM). Imagine implied volatility and stock price stay constant (real markets won’t, but this isolates the idea).
| Days to Expiration | Option Premium | Intrinsic | Extrinsic |
|---|---|---|---|
| 60 | 3.20 | 0.00 | 3.20 |
| 30 | 2.30 | 0.00 | 2.30 |
| 10 | 1.20 | 0.00 | 1.20 |
| 3 | 0.65 | 0.00 | 0.65 |
Notice how the extrinsic value drops by 0.90 from 60→30 days, then by 1.10 from 30→10 days, then by 0.55 from 10→3 days. The “per-day” decay is not constant.
Also note: deep ITM options often have less extrinsic value (more of their premium is intrinsic), while near-ATM options often have the most extrinsic value and can be most sensitive to time decay.
Activity: Classify Moneyness and Split Premium
For each contract below, do three things:
- Classify as ITM / ATM / OTM.
- Compute intrinsic value.
- Compute extrinsic value = premium − intrinsic.
Assume premiums are per share.
Set 1 (Stock price given)
| Contract | Stock Price (S) | Type | Strike (K) | Premium |
|---|---|---|---|---|
| A | 98 | Call | 100 | 2.40 |
| B | 98 | Put | 100 | 4.90 |
| C | 105 | Call | 100 | 7.80 |
| D | 105 | Put | 100 | 1.10 |
| E | 50 | Call | 50 | 1.75 |
Answer Key (Show Your Work)
Contract A: S=98, Call K=100, Premium=2.40
- Moneyness: OTM (call is ITM only if S>K)
- Intrinsic:
max(98−100,0)=0 - Extrinsic:
2.40−0=2.40
Contract B: S=98, Put K=100, Premium=4.90
- Moneyness: ITM (put is ITM if S<K)
- Intrinsic:
max(100−98,0)=2.00 - Extrinsic:
4.90−2.00=2.90
Contract C: S=105, Call K=100, Premium=7.80
- Moneyness: ITM
- Intrinsic:
max(105−100,0)=5.00 - Extrinsic:
7.80−5.00=2.80
Contract D: S=105, Put K=100, Premium=1.10
- Moneyness: OTM
- Intrinsic:
max(100−105,0)=0 - Extrinsic:
1.10−0=1.10
Contract E: S=50, Call K=50, Premium=1.75
- Moneyness: ATM (S≈K)
- Intrinsic:
max(50−50,0)=0 - Extrinsic:
1.75−0=1.75
What Can Change Extrinsic Value? (High-Level Drivers)
Extrinsic value is the market’s pricing of uncertainty and opportunity. Several inputs can change it—sometimes quickly.
1) Time to Expiration
- More time remaining usually means more extrinsic value.
- As expiration approaches, extrinsic value tends to shrink; the sensitivity to time passing is captured by theta.
2) Implied Volatility (IV)
- Higher IV generally increases extrinsic value because the market is pricing a wider range of potential future prices.
- Lower IV generally decreases extrinsic value, even if the stock price doesn’t move.
3) Interest Rates (High Level)
- Rates can influence option pricing through the cost/benefit of paying for stock later versus now.
- In many everyday retail situations, the effect is smaller than time and volatility, but it can matter more for longer-dated options.
4) Dividends (High Level)
- Expected dividends can affect option prices because dividends tend to reduce the stock price when paid (all else equal).
- This can shift relative value between calls and puts and can change extrinsic value, especially around ex-dividend dates.
Mini-Practice: “What Changed?”
Imagine a stock stays at 100 and you’re watching the 100-strike call. If the premium rises from 2.00 to 2.80 without the stock moving, intrinsic is still 0, so the entire change is extrinsic. At a high level, likely explanations include: more time remaining (rare unless you switched expirations), higher implied volatility, changes in rates, or dividend expectations.
