Intrinsic Value, Extrinsic Value, and Option Premium

Option premium is often discussed as intrinsic value plus extrinsic value.

Intrinsic value

A call has intrinsic value when the underlying is above the strike. A put has intrinsic value when the underlying is below the strike. Intrinsic value does not include the premium originally paid.

Extrinsic value

Extrinsic value reflects time, implied volatility, rates, dividends, supply and demand, and model assumptions. It can fall even when the underlying moves in the expected direction.

Moneyness

In-the-money, at-the-money, and out-of-the-money describe the relationship between strike and underlying price. They do not, by themselves, tell you whether a trade is profitable.

The practical lesson

A call can finish above its strike and still produce a loss for the buyer if intrinsic value is less than the premium paid. Always calculate the position’s break-even under the intended measurement point.