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Option Valuation

An option's price (premium) is the sum of two components: intrinsic value and extrinsic value.

Premium=Intrinsic Value+Extrinsic Value\text{Premium} = \text{Intrinsic Value} + \text{Extrinsic Value}

Intrinsic Value​

Intrinsic value is what the option would be worth if it expired right now. It's the "real" value based on current price vs strike.

OptionIntrinsic Value
CallS − K (if S > K, else 0)
PutK − S (if K > S, else 0)

Where S = spot price, K = strike price.

Spot Price (S)$103k
$70k$130k
K = $100k
CallITM
$3k
020K
S − K = 103 − 100 = 3
PutOTM
$0k
020K
K ≤ S → intrinsic = 0
note

Intrinsic value is never negative. OTM options have zero intrinsic value, not negative.

Extrinsic Value​

Extrinsic value (also called time value) is everything above intrinsic value. It represents the probability that the option could become more valuable before expiry.

Extrinsic Value=Premium−Intrinsic Value\text{Extrinsic Value} = \text{Premium} - \text{Intrinsic Value}

What Drives Extrinsic Value?​

FactorEffect
Time to expiryMore time = more extrinsic value
Implied volatilityHigher IV = more extrinsic value
MoneynessATM options have the most extrinsic value

Time Decay (Theta)​

Extrinsic value decays as expiry approaches. This is called theta decay.

  • ATM options lose extrinsic value fastest near expiry
  • At expiry, extrinsic value = 0 (only intrinsic remains)
Option Type
What this means
KSOTMITMSpot = Strike (at the money)
Day 0 Value
$2,000
Day 0 Value
$2,000
Cumulative Loss
$0
$0$1k$2kToday30dExpiryDaily decay−$17/day
Drag to simulate time passingDay 0
060 days
ATM options decay fastest - they have the most extrinsic value and highest uncertainty about finishing ITM or OTM.

Visualizing the Components​

Example
$100k call @ $6.0k
Spot: $103k
Intrinsic$3,000
Extrinsic$3,000
Total Premium$6,000
Intrinsic Value
$3,000
Value if exercised now
$103,000
-
$100,000
=
$3,000
Extrinsic Value
$3,000
Time value + volatility premium

At expiry, extrinsic value decays to zero - only intrinsic value remains.

At Expiry​

At expiration:

  • Extrinsic value = 0 (no time left)
  • Premium = Intrinsic value only
  • Settlement is based purely on S vs K

This is why European options (like on Hypercall) are simpler to reason about - you only need to think about where spot ends up relative to strike.

Key Takeaways​

  1. ITM options have intrinsic value (they're "in the money")
  2. OTM options are pure extrinsic value (betting on movement)
  3. ATM options have the most extrinsic value (highest uncertainty)
  4. Time decay erodes extrinsic value, accelerating near expiry

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