Traders often see options as having two kinds of premium - intrinsic value and time value. But this is not accurate. A third type of premium is where all of the uncertainty lies.
Intrinsic value is easy to calculate. It is equal to the number of points the option is in the money. For example, a company is valued at $38 per share on January 2, 2014. At that time the JAN 40 put was worth 2.12. This call was in the money 2 points (40 strike less 38 current stock price). So the premium included $200 of intrinsic value. At the same time, the January 40 call was worth 1.43. This contained no intrinsic value since the call's strike was higher than the current stock price.
Just as intrinsic value is easily understood, so is time value, the second type of premium. Time value is very predictable. It represents the passage of time until expiration, and as expiration nears, the time value falls at an accelerating rate. This time decay is at its fastest pace in the last month of the option's life.
But have you noticed that longer-term options experience in-the-money price movement but the price is not responsive? For example, the price might move up three points but the ITM calls only change by two points. Doesn't this defy the intrinsic value rule?
No. In fact, both intrinsic and time value are predictable and inflexible; they always act in the same manner. The lack of response in both long-term options and far out of the money options is due to the third type of option premium: extrinsic value, perhaps better known as implied volatility.
In the example of the unresponsive ITM call, the intrinsic value tracks ITM options point for point with the underlying. However, the extrinsic value offsets that tracking by taking away from the premium (or, in the case of a falling underlying, the option might not fall as many points because extrinsic value moves upward). Why? Because the longer the time until expiration, the more uncertainty there is about whether the option will end up in or out of the money.
Extrinsic value is also going to vary as the gap between the underlying price and the option's strike narrows. So when there is a lot of time to expiration and the strike is far away from current price, don't expect a lot of tracking even when the underlying moves rapidly. But as time nears for expiration and as the price of the underlying approaches the option's strike, you will see increasing point-for-point ITM responsiveness. The combination of time (to expiration) and proximity (between price and strike) determine how extrinsic value moves.
Only by dividing option premium into all three groups can you appreciate the role of extrinsic value. Remember the attributes of all three premium types:
Intrinsic value is equal to the points the option is in the money (strike above market value for calls, or strike below market value for puts).
Time value is a predictable form of value associated strictly with time remaining until expiration. Time decay accelerates as expiration approaches.
Extrinsic value, or implied volatility, is the value caused by the uncertainly of outcome. This is affected by time to expiration and proximity between strike of the option and price of the underlying.
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