When trading options, it's important to understand the difference between intrinsic value and extrinsic value.
And in doing so, it could mean the difference between making money and losing money.
Everybody knows what 'intrinsic' means in regular everyday life: real, innate, inherent, of within.
In options, the concept is the same.
The definition of intrinsic value as it pertains to options is: the difference between the underlying stock price and the option's strike price (that's in-the-money).
For example: if a stock was trading at $50, and a $45 call option was selling for $6.50, that option would have $5 of intrinsic value.
$50 stock price - $45 call option = $5. If the option premium is worth $6.50, that means $5 of that is intrinsic value.
In this example, that represents 77% of the value. And in general, I like the options I purchase to have at least 60% to 70% of intrinsic value.
The other $1.50 in the example above is extrinsic value, also known as 'time value'.
Extrinsic Value (aka Time Value)
Extrinsic value is the amount of the premium that's not comprised of intrinsic value. This part of the premium is said to be your 'time value'. Out-of-the-money options are comprised of only time value.
Using the same example as above:
A $6.50 premium - $5 intrinsic value = $1.50 of extrinsic value.
So the key to remember is that options are comprised of two parts: intrinsic value and extrinsic value, i.e., time value.
So what's the difference for the investor?
In the beginning, for all practical purposes, nothing.
If I bought an option at $500 and then sold it for $800, whether half of that was comprised of intrinsic value or none of it was comprised of intrinsic value, it makes no difference from that standpoint.
But ultimately, at expiration, when there's no time left of the option, your option's sole value will be its intrinsic value.
So at that point it makes all the difference.
For example: if I had a $50 call option with 2 months of time on it, and the price of the underlying stock was at $45, that option might be worth $3.50 or $350. And at that point, the premium is comprised on only time value.
But now - fast forward two months - if that stock is still at $45, that option is $5 out-of-the-money, meaning it has no intrinsic value. And since it's now expiration, the time has run out, which means there's no time value either, which also means that the option is worthless.
If on the other hand, the stock was at $53 at expiration, the option is now $3 'in-the-money'. All of the time value has disappeared. But it's now got $3.00 of intrinsic value (because it's $3 'in-the-money), which means your option is worth $300 if you were to sell it.
And that's why I like to buy my options with intrinsic value to begin with (i.e., in-the-money options). I may have to pay a little more for them. But it totally changes my risk to reward profile for the better.
Most people have too high expectations for the underlying stock's move. And usually, they expect the move to happen too quickly. So they scrimp on time, and try to get extra leverage by buying out-of-the-money options.
But when the move they expected to see doesn't materialize, they lose everything. Even if it goes up to their strike price, they're still out.
But if you buy in-the-money options, the worst case scenario is if your option trades sideways, you'll lose only a portion of your premium rather than all of it. And if it goes up even a little, oftentimes that will still result in a profit whereas with an out-of-the-money option, you've lost it all.
So understanding intrinsic value is important so you can determine your potential profit and loss scenarios with your options strategies.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.