Intrinsic Value is when the value of the option is seen to be determined solely by the price of the underlying instrument. Extrinsic Value introduces a range of other price determinants and understanding the difference between the two partly explains why people like trading options.
An Option that is very much ‘in the money’ will trade in line with the underlying instrument as it is extremely likely that the options will convert to the underlier. If for example a Call option has a Strike price of $10 and the underlier is trading at $70 then the Intrinsic Value of the Option is $60. If the Underlier goes up in price by $1 then so will the Option.
The difference, between Option Market Price and Intrinsic Value is what is known as Extrinsic Value. In the above example the Option will likely trade at $71 because the market will allocate some Extrinsic Value to the options.
The major determinants of Extrinsic Value are Time and Price Volatility and Extrinsic Value is indeed sometimes referred to as Time Value.
If you are holding a position in an Option, then you have the opportunity (though not the obligation) to convert that position into the underlying instrument. That ability to convert is constrained by time and the deadline by which they have to be exercised is known as the Expiry date. The greater the number of days until Expiry the more chance that price can move, and the greater the Extrinsic Value of the option.
Implied Volatility is the measure of the amount a price can change over a particular time. You may have one option position where there is 100 days left until Expiry date but if the price volatility is near to zero then there is little chance of anything ‘interesting’ happening in that time and Extrinsic Value will be lower.
Real Life Valuations
The concept of Extrinsic Value is borne out by real-life observations which shows that Options often trade at prices other than that suggested by the Intrinsic Value calculation.
Heinken AB. Stock and Option monitors
Source: Interactive Brokers 20181127
Stock Mid-Price: EUR 80.97
The difference between the mid-price of the Underlier and the strike Price of the EUR 74 call = EUR 6.97. This means the Intrinsic Value of the option is EUR 6.97.
The price monitor for options relating to the underlier shows that the Call Options in question; with 80 days until expiry and Strike Price of EUR 74 are currently trading with Mid-price of: EUR 7.725 which is a higher price than the intrinsic value of EUR 6.97. Which raises the question: why is an option with Intrinsic Value of EUR 6.97 trading at a price of EUR 7.725?
The difference between the price of an Option and its Intrinsic Value is the Extrinsic Value which in the above example = 7.725 – 6.97 = 0.755.
The Extrinsic Value reflecting that having the right to take a position is often preferable to actually taking the position itself as then you have to manage it and would be liable for any market risk that might apply. If you are holding the Heineken EUR 74 calls and the market tanks, then you can walk away, buy yourself a beer, and limit your losses to the premium you paid to buy them.
(Note the profit on the trade and Intrinsic Value should differ as net profit will factor in the premium paid to buy the position in the first place.]