Beginning options traders soon learn about extrinsic value. If they don't learn about it on their own, the market is more than willing to teach them a few painful lessons.
Extrinsic value is also known as time value, although that term can be a little misleading. In the chart below from OptionNET Explorer, the column titled "T. Prem" lists the extrinsic value of various options.
Extrinsic Value, Portion of Option Chain from OptionNet Explorer, Thursday, October 3, at 2:55 CT, with RUT at 1071.34:
For example, we see that, with the RUT at 1071.34 at the time, the mid-price or mark of a RUT 1090 OCT 13 Put was $27.35. This $27.35 was composed of two parts: the intrinsic and extrinsic values. The intrinsic is the amount the put is in the money. That can be computed by subtracting the current price level from 1090: $1090 - $1071.34 = $18.66. Therefore, $18.66 of the $27.35 value is intrinsic value. That leaves $27.35 - $18.66 = $8.69 in extrinsic value. That's the amount displayed in the column "T. Premium."
Scan these options charts for both calls and puts and notice that time premium is biggest in the at-the-money (or near the money) 1070 strike on both the call and put side. This is the typical pattern. You're paying the most extrinsic value or time premium when you buy an at-the-money option. You're selling the most time premium when you sell one. Does that mean that you should never buy an at-the-money option and should always sell one? Not necessarily, but especially if you're buying a lone call or put, you should be aware that you're paying a hefty amount of extrinsic value as compared to other strikes.
To call extrinsic value "time value" or "time premium" can be both self-explanatory and misleading. The amount of extrinsic value or time value is, of course, related to the time to expiration. That part is the self-explanatory part. For example, the 1070 OCT 13 put had, on that same day, a value of $16.50, all of which was extrinsic value. We see 16.50 in the "T. Prem" column, reflecting that the entire value of the option is extrinsic value or time premium or value, as it is sometimes called. If the RUT settled at expiration Friday morning, at its then-current value of 1071.34, that 1070 put would be worthless. All that time premium or value will have decayed. The extrinsic value, then, is related to the decay that will occur over time. We know, too, that the longer the time is until expiration, the more time premium or value an option might have.
Let's look at that OCT 13 1090 Put option's extrinsic value ten days earlier, when the RUT was at 1071.94, only $0.60 above its value when the previous chart was snapped.
Option Chain on September 23, with RUT at 1071.94:
We see that, with ten extra calendar days to expiration, the time premium or value of the OCT 13 Put was $9.94, larger than the $8.69 seen earlier.
But wait a minute. Does this tell the entire story? Note the implied volatility for this option, 15.64 percent, is written in the "IV" column before the "T. Premium." That same option had an IV of 18.82 percent on the first chart displaying conditions ten days later.
Let's look at a third chart, this one from September 24, when the RUT was at 1071.93, just one cent different from the price when the September 23 chart was snapped.
Option Chain from September 24, with RUT at 1071.93, One Cent Different than that from September 23 Chart:
If extrinsic value is just time premium or value, and price hasn't changed much and only one day has passed and it's still far enough from expiration that decay hasn't rapidly increased, then we would expect the extrinsic value to be only slightly smaller than on September 23. However, time premium on September 24 for the OCT 13 1090 put was only $8.48, and we remember from the previous chart that it was $9.94 the previous day. Moreover, we know from the first chart that it was $8.69 about ten days later when price was near the same level, after a considerable amount of time to decay. What gives?
IV for that option was 14.51 percent on September 24, less than the 15.64 percent seen on September 23 and far less than the 18.82 percent seen about ten days later, shown on the first chart in the article. It turns out that changes in implied volatility impact the extrinsic value, too, resulting in a drop in extrinsic value that might have been greater than anticipated from the one-day passage of time and one-cent different in price. A rise in implied volatility of an option typically increases the extrinsic value while a decrease in implied volatilities typically decreases the extrinsic value. That's not "time value" alone that you're seeing.
That can be important to remember. If you buy a call, for example, when implied volatilities are high--as they might be in the moments immediately after price breaks through some upside resistance barrier, for example--you're probably buying an option with a higher implied volatility. That makes that option an expensive option. Sometimes, after a first price break upward, prices will dip a little and or maybe just steady, and implied volatilities will drop down again and stay relatively steady or even decline when prices start climbing again. The call buyer who bought five minutes earlier might find herself with an option that has lost money even as the price climbs past the point at which she bought the call. Price might have to move a lot higher than expected before that call is profitable enough to pay for commissions and the deflated extrinsic value.
If a rally is rapid enough or if it's preceding an important event, implied volatilities might remain high. Many people and institutions might be trying to buy at the same time, with demand keeping the price high, but you can't count on that happening with a steadier climb. In the case of a steady climb, you're likely to see a bit of a "vol crush." The trader trying to play an upside breakout with a long call purchase has to make some judgment calls, then, about whether to risk jumping in with expensive calls and hope that the climb is rapid enough to overcome any decay in extrinsic value due to a decrease in implied volatilities.
The put buyer who wants to trade a breakdown by buying a long call may have it a bit easier since implied volatilities tend to increase when prices decline. At the moment of the breakdown, however, implied volatilities also tend to rise rapidly and may settle down a bit afterwards.
We'll talk more about extrinsic value in another article. If you're not experienced in thinking about how implied volatilities will impact the extrinsic value of an option, you might simulate a trade with a long call or put and change the implied volatilities to watch the impact. Remember that changes in implied volatility can't impact the intrinsic value--only a price change can do that. Therefore, the more extrinsic value there is in an option or the higher proportion of its value is extrinsic value, the more its value will be impacted by a change in implied volatilities. When you have a sense of how that works, then you can simulate changes in price, implied volatilities and time to expiration to get a better feel for how they all work together.