The definition of extrinsic value implies the measurement of the difference between its intrinsic value and a market option. Extrinsic value also represents a part of a worth assigned to an item or an option by external factors. The opposite of such value is intrinsic value.
Explanation:
There is a simple formula for calculating the extrinsic value: one should subtract the intrinsic value from the total cost. Both types of value constitute a premium or the total cost of a stock option. The option premium or price depends on external factors such as time, so the extrinsic value is also called “time value.”
The time affects the cost of an option because when there is no time left, the contract expires. Basically, the extrinsic value denotes the price of an option at the moment of its expiration. So, when the deal gets closer to the expiration date, there is less time for an asset to move favorably. For instance, the option having one week until expiration has less extrinsic value than the option that goes out of date in a month.
Another factor influencing extrinsic value is named implied volatility. Implied volatility gauges the quantity of asset that can be moved within a specified period of time.
When the implied volatility rises, the external value rises as well. For example, when one buys an option, including annualized implied volatility equal to 30%, the implied volatility increases by up to 40%, so the extrinsic value rises as a result. This is the crucial reason for investors to buy options rather than stocks because stocks cost more and do not have expiration dates. The market realizes that the price may change, so they add extrinsic value to compensate for these changes in time and volatility.