The features and functions of stock market options allow for some of the most creative trading strategies in any of the various trading markets. One reason for the ability of options traders to strategize for any conceivable market condition is how options are priced. The combination of intrinsic and extrinsic value is unique to options contracts.
An option contract gives the buyer the right to buy or sell an underlying security -- typically stock or exchange traded fund, or ETF, shares -- at a specific price. Put options give the right to sell the underlying stock, and call options reserve the right to buy. The exercise or strike price of an option is the price at which the stock will be bought or sold if the option is exercised. One stock will have many options with different strike prices and expiration dates trading against it.
Because options on a specific stock are available with a range of strike prices, the "moneyness" of an option has a direct effect on the value of a specific option. Consider a stock with a share price of $25 and three different options with strike prices of $20, $25, and $30. For call options, the $20 strike price is in-the-money -- ITM, the $25 strike option is at-the-money -- ATM -- and the $30 strike price puts the option out-of-the-money -- OTM. For puts, the order is reversed -- the $30 strike option is the ITM contract.
An ITM option has intrinsic value by the amount it is "in-the-money." A call option with a $20 strike price on a stock currently at $25 is in-the-money by $5. If you held this call option, you could exercise the option and buy the shares for $20 and immediately sell the shares for $25, pocketing the $5 per share intrinsic value. Options that are out-of or at-the-money have no intrinsic value.
The extrinsic value of an option is the portion of an option price that is not intrinsic value. If the price of the $20 strike call option on the $25 stock is $7, the $2 above the $5 intrinsic value is the extrinsic value. Out-of-the money and at-the-money option prices consist of only extrinsic value. This value is often referred to as time premium. The time premium is the value in an option's price that covers the rights given by the option contract in relation to the time until the option expires.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.