Intrinsic value put option graph
Consider the graph above, which shows the BS value of a simple European call under typical parameters. Time value is maximal at-the-money, since this is the point where the implicit insurance that the option provides is most useful to us far in- or out-of-the-money, the option is only useful if there are large price swings, which are unlikely.
What is the extra value that we should assign to an American call relative to a European call due to the extra optionality it gives us? In the case of an American option, at any point before expiry we can exercise and take the intrinsic value there and then.
This means that we can sell the option on the market for more than the price that would be received by exercising an American option before expiry — so a rational investor should never do this, and the price of a European and American vanilla call should be identical. It seems initially as though the same should be true for put options, but actually this turns out not quite to be right.
Consider the graph below, showing the same values for a European vanilla put option, under the same parameters. Notice that here, unlike before, when the put is far in-the-money the option value becomes smaller than the intrinsic value — the time value of the option is negative!
What is it that causes this effect for in-the-money puts? It turns out that it comes down to interest rates. Roughly what is happening is this — if we exercise an in-the-money American put to receive the intrinsic value, we receive cash straight away.
But if we left the option until expiry, our expected payoff is roughly , where is the forward value. It's essentially the part of the price that accounts for the risk being taken by the writer of the option. Extrinsic value is basically the true cost of owning an option, because any intrinsic value that you pay for is already reflected in the current theoretical profit of the contract. The reason extrinsic value is sometimes known as time value is because one of the main factors which affect the extrinsic value of an options contract is the time left until it expires.
Generally speaking, the extrinsic value will be higher when there is more time left. As a contract moves toward the expiration date, the extrinsic value will typically decrease due to time decay, and there's less time for the price of the underlying security to move. Time value isn't a particularly accurate label for extrinsic value though, because there are more factors involved than just the time element. To truly understand extrinsic value, you need to understand how pricing models, such as the Black Scholes Model, work and aid in Options Trading.
However, when you are just getting started with options trading, it's sufficient to understand just the basic principles. Mainly the fact that it represents the true cost of owning an option and serves as compensation to the writer of the contract for the risk they are taking.
Accurately calculating extrinsic value can be quite complicated, and again you really need to understand options pricing models, but there is actually a relatively simple way to work out how much you are paying in extrinsic value for any options contract you buy.
As we have mentioned above, any options contracts that are either at the money or out of the money have no intrinsic value. Therefore, the price of any at the money option or out of the money is made up entirely of extrinsic value. For an in the money contract, the extrinsic value can be determined simply by deducting the intrinsic value from the price.
Quite simply, providing you know the price of an option and can calculate the intrinsic value, then it's easy enough to also calculate the extrinsic value. The bid price and the ask price of options aren't affected by how actual prices are determined, but rather by how options are bought and sold on the exchanges. Whenever you see the price of options quoted on the exchanges, you will see two prices listed: You really need to understand the difference between these prices and why this difference exists.
The bid price for any particular contract is the price at which you can sell, or write, those contracts for. The ask price is the price at which you can buy those contracts, and will always be higher than the bid price at any given point in time.
The difference between the bid price and the ask price is the bid ask spread, this is the built in margin that helps determine the cost of options. It's important that you are aware of this, because this margin is effectively a cost of trading.
If you are actively trading and buying and selling contracts on a regular basis, then the bid ask spread can have a significant impact on your profits. For example, if you buy contracts with the intention of selling as soon as there is a small increase in the price, that increase must be bigger than the size of the bid ask spread if you want to make a return. The main reason that the bid ask spread exists is to attract market makers into the marketplace.
Market makers basically exist to ensure that there is enough liquidity in the market for traders to buy and sell the options they wish to trade. If there isn't enough buyers and sellers, then the market can stagnate and it's difficult to execute your chosen transactions.
Market makers resolve this problem by effectively stepping in to facilitate a trade when one party wishes to buy or sell, but there's no other party willing to fill the other side of the transaction. In return for keeping the market moving, market makers are able to buy at the bid price and sell at the ask price, thus making a small margin on every trade they make.
Most quotes also contain another price: This is the last price that a particular contract was traded at. With certain financial instruments, the last price is particularly significant, but it isn't hugely relevant when trading options.