Options 101 · Module 3 of 10
Premium, intrinsic and extrinsic value, moneyness
In this lesson
Split premium into intrinsic + extrinsic, classify ITM/ATM/OTM for calls and puts, and explain the trade-offs of strike choice.
- 5
- short parts
- 12
- questions
- ~15
- minutes
Read the whole lesson on one page
Premium, intrinsic and extrinsic value, moneyness: the lesson
Every price has two parts
| Call | Strike | Put |
|---|---|---|
| 5.22 | 45 | 0.22 |
| 1.72 | 50 | 1.72 |
| 0.30 | 55 | 5.30 |
Stock at $50. Shaded prices are in the money; the outlined row is at the money.
Illustrative numbers, not real quotes.
- Step 1: The 45 call costs 5.22 with the stock at 50.
- Step 2: If you exercised right now, you'd gain 50 − 45 = 5.00. That's the intrinsic value.
- Step 3: The other 0.22 is extrinsic value: what people pay for time and for the chance of a bigger move.
Intrinsic value
Intrinsic value is how far an option is in the money. It can't be negative, because you'd never exercise a right that loses money.
- Call: max(0, stock − strike). A 70 call with the stock at 80 has 10.00.
- Put: max(0, strike − stock). An 85 put with the stock at 80 has 5.00.
- A 90 call with the stock at 80 has 0. You wouldn't buy at 90 what sells for 80.
Extrinsic value
Extrinsic value pays for two things: time left, and how much the stock might move. It's biggest at the money, where the outcome is least certain. It shrinks to zero by expiration.
Model values, not real quotes.
In, at and out of the money
| Call | Put |
|---|---|
| In the money: stock above the strike | In the money: stock below the strike |
| At the money: stock near the strike | At the money: stock near the strike |
| Out of the money: stock below the strike | Out of the money: stock above the strike |
With the stock at 50, the 45 call is in the money by 5.00 and the 45 put is out of the money. Out-of-the-money options have no intrinsic value at all.
Choosing a strike is a trade-off
| 45 call, in the money (5.22) | 55 call, out of the money (0.30) |
|---|---|
| Costs $522 per contract | Costs $30 per contract |
| Breakeven: 50.22 | Breakeven: 55.30 |
| Stock stays at 50: −$22 | Stock stays at 50: −$30 |
| Stock reaches 60: +$978 | Stock reaches 60: +$470 |
| Moves almost dollar for dollar with the stock | Needs a big move to pay off |
Worked example: Five options on a $50 stock, 30 days out
Illustrative numbers, not real quotes.
Stock at $50. Split each price into intrinsic and extrinsic value:
| Option | Price | Moneyness | Intrinsic | Extrinsic |
|---|---|---|---|---|
| 45 call | 5.22 | ITM | 5.00 | 0.22 |
| 50 call | 1.72 | ATM | 0 | 1.72 |
| 55 call | 0.30 | OTM | 0 | 0.30 |
| 45 put | 0.22 | OTM | 0 | 0.22 |
| 55 put | 5.30 | ITM | 5.00 | 0.30 |
- The 45 call: stock 50 − strike 45 = 5.00 intrinsic. The other 0.22 is extrinsic.
- The 55 put: strike 55 − stock 50 = 5.00 intrinsic. The other 0.30 is extrinsic.
- The ATM 50 call has no intrinsic value, yet carries the most extrinsic value, 1.72.
Now the trade-off. Here is each call's P&L per contract at expiration:
| Stock at expiration | 45 call (5.22) | 50 call (1.72) | 55 call (0.30) |
|---|---|---|---|
| 50 | −$22 | −$172 | −$30 |
| 55 | +$478 | +$328 | −$30 |
| 60 | +$978 | +$828 | +$470 |
- The cheap 55 call loses only $30 when the stock sits still, but it needs the stock past 55.30 to profit.
- The 45 call loses only $22 if the stock stays at 50, because 5.00 of its 5.22 price is intrinsic value that is still there at expiration.
Education only, not investment advice. Options involve risk. Read the OCC's Characteristics and Risks of Standardized Options. Example numbers are illustrative.