Introduction

The table above can be used to calculate options' intrinsic value, extrinsic value, extrinsic value per day(EV/d) which could be useful to develop short premium trading strategies.

Option Price

Option price, aka option premium is the income received by an investor who sells or "writes" an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire. For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares.

The components of an option premium include its intrinsic value, its time value and the implied volatility of the underlying asset. But for the sake of simplicity here we divide it into two separate components: intrinsic value and extrinsic value. As the option nears its expiration date, the time value will edge closer and closer to $0, while the intrinsic value will closely represent the difference between the underlying security's price and the strike price of the contract.

Intrinsic Value

Intrinsic value is relatively simple to calculate because it essentially represents the theoretical built in profit of an options contract at a specific point in time. For example, a call with a strike price of $20 on an underlying security that was trading at $25 would have an intrinsic value of $5. Technically it could be exercised to buy the underlying security at $20, which could then be sold at the market price of $25 for a $5 profit. This $5 profit represents the intrinsic value of the contract. If the underlying security was trading at $20 or below, then the call would have no built in profit and therefore no intrinsic value.

Extrinsic Value

Extrinsic value is slightly more complex, because it's less tangible than intrinsic value. In some ways, the extrinsic value is really the true cost of owning an options contract, because it's effectively the money that you pay for the possibility of being able to benefit from price movements in the underlying security. For example, if you bought at the money calls with a strike price of $30 on an underlying security that was trading at $30 there would be no intrinsic value, only extrinsic value. If the cost of each contract was $2, then you would basically be paying $2 for the right to take advantage of any upward price movement of the underlying security.

There are a number of factors that affect extrinsic value, and time is one of those factors. In fact, extrinsic value is often referred to as time value because time is considered to be the most important factor. Because contracts have a fixed expiration date, there' always a limited amount of time for the price of the underlying security to move favorably for the holder. The longer there is until expiration date, the more chance there is for the underlying security to move and therefore the more chance for the holder to make a profit.