What Determines an Option's Extrinsic Value?

An option's extrinsic value depends on a few factors:

1) Whether the option is in-the-money, at-the-money, or out-of-the-money.

2) How much time the option has until it expires.

3) The implied volatility of the options

First, options that are further in-the-money have more intrinsic value and less extrinsic value, and was visually demonstrated in the previous sections. As an option becomes further in-the-money, its value will shift towards intrinsic value.

At-the-money options will have the most extrinsic value of any option, while out-of-the-money and in-the-money options have less extrinsic value the further the strike price is from the stock price.

Second, options with more time to expiration are more expensive, and therefore have more extrinsic value than options at the same strike price with less time to expiration.

In the following visual, we'll compare four call options on the S&P 500 ETF (SPY) with varying days to expiration (DTE). With the SPY at $216, we'll look at the 216 call in each respective expiration cycle. Let's take a look!

As you can see, longer-term options at the same strike price are more expensive, and therefore have more extrinsic value. This is because there is more time left until the option expires, and therefore more time for the option to increase in value due to stock price changes.

Lastly, options on higher implied volatility stocks have more extrinsic value. To validate this, let's look at the 100 calls with 30 days to expiration on three stocks that are trading for $100. Note how the higher option prices indicate higher implied volatility.

Why is this? Option prices determine implied volatility. When the future movements of a stock's price are expected to be volatile, market participants are willing to pay more for protection, or to speculate on those movements (in other words, supply/demand leads to higher option prices, and therefore implied volatility).

All else being equal, if you look at two similarly-priced stocks, the stock with more expensive options will have higher implied volatility.