Option premium: intrinsic and extrinsic value

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The premium is simply the option's price. It is quoted per share, so a quote of $2.40 means $240 for a standard contract covering 100 shares. The buyer pays it; the seller collects it.

Every premium splits into two parts. Intrinsic value is what the option would be worth if exercised immediately. Extrinsic value is everything above that: the market's charge for the time remaining and for the possibility that the stock moves.

Out-of-the-money options have no intrinsic value at all, so their entire premium is extrinsic. That is why they can lose value even while the stock stands still: the possibility they price is expiring day by day.

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Premium = Intrinsic value + Extrinsic value

A worked example with the stock at $100 and two calls on the same 30-day expiration:

• The $95 call trades at $7.10. Exercising it means buying shares worth $100 for $95, so intrinsic value is $5.00. The remaining $2.10 is extrinsic.
• The $105 call trades at $2.40. Exercising it would mean overpaying, so intrinsic value is zero and the whole $2.40 is extrinsic.

Intrinsic value is pure arithmetic: for calls, stock price minus strike when positive; for puts, strike minus stock price when positive; zero otherwise. It changes only when the stock changes.

Extrinsic value is where the market's judgment lives. Its main drivers are time to expiration and expected movement, expressed as implied volatility, with interest rates and dividends playing smaller supporting roles. When traders describe an option as richly or cheaply priced, they are talking about the extrinsic part; the intrinsic part is not up for debate.

The split also explains behavior near expiry. The $95 call above cannot trade much below $5.00 while the stock holds at $100, but its $2.10 of extrinsic value will bleed toward zero as the clock runs down, at a pace measured by theta. One summary of what all that extrinsic pricing implies about movement is the expected move.

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Precisely: intrinsic value is max(S − K, 0) for a call and max(K − S, 0) for a put, where S is the stock price and K the strike. Extrinsic value is the traded premium minus that quantity, and it is never meaningfully negative in a functioning market; a listed option cannot trade below intrinsic value for long, because arbitrage closes the gap.

Extrinsic value is often called time value, but the label undersells it. Two options with identical time remaining routinely carry very different extrinsic value because the market expects different amounts of movement; that expectation is the implied volatility surface. A standardized 30-day reading of it is described under IV30.

A common misconception treats extrinsic value as a fee that buyers lose by definition. It is a price for uncertainty, paid by one side to the other, and either side of the trade can end up better off once the uncertainty resolves. Deep in-the-money options, with little extrinsic value, behave nearly like stock; the interesting pricing questions concentrate where extrinsic value dominates.