Because options are most often priced directly on mathematical models of the underlying stock’s current and historical price (the intrinsic value), the extrinsic value is a measure of the decay in value of an option as it nears its expiration date.
The longer an option has until expiration, the greater the chance that at some point in time it will increase in value and be exercised (assuming American style options).
Extrinsic Value and Time Decay
The decay of an option’s value with time is an integral feature of derivatives trading, and is one of the most important measures alongside it the historical price path of the underlying equity.
The historical variance of a stock’s price will also play a role in the extrinsic value of its options, as it will contribute to the estimates concerning the potential for price movement within the lifetime of the option.
Other Factors Affecting Extrinsic Value
There are a number of other factors besides the decay of value with time that can lead to an extrinsic value.
For example, an illiquid market could lead to significantly divergent prices, as could a significant event whose relevance is disputed among market participants. Whatever the cause of a certain extrinsic value, the general pricing of options makes it noteworthy when there is a divergence of prices.
Any trader who wishes to trade in the derivatives market needs to be aware of how options are priced intrinsically, and how the extrinsic value of an option can diverge from that price.
Any extrinsic value that cannot be tied directly to the time decay of an option’s intrinsic value represents a potential trading opportunity.