Extrinsic Value versus Intrinsic Value: In Binary Options, assets have two values that determine the total value of the asset or option.
While intrinsic value refers to the built-in (tangible) value of the asset at expiration, the extrinsic value represents the external factors that add on the intrinsic value.
What is an Extrinsic Value in Binary Options?
Extrinsic value refers to one of two parts of a stock option’s price, which is influenced mainly by time value and implied volatility.
The extrinsic value of a stock option is kept as profit by the writer of the option regardless of the nature of the option (whether it is in-the-money or out-of-money). Therefore, you could see the extrinsic value as compensation to the writer for undertaking the risk of writing an option.
Factors that influence Extrinsic Value in Binary Options
As already mentioned, two major factors influence the extrinsic value in Binary Options:
- Time Value or Length of Contract
This refers to how much longer an option has before expiry. The more time the option gets the more valuable it is. The reason is because writers get to take on more risk for the option, so they should be duly compensated. And, the holder gets an option that has more time to move in favor of the holder, which makes it very valuable.
- Implied Volatility
This aspect takes into account the leeway a stock price has to make changes over a given timeframe. This is valuable because, volatile options can lead to high return.
Therefore, if the volatility in an underlying decreases, less return could be made from the option, and its extrinsic value decreases accordingly.
Aside these two factors, two other factors that influence the extrinsic value in binary options are:
- Interest rate changes
- Dividends of the underlying stock
Nature of Extrinsic Value in Binary Options
Extrinsic value follows certain patterns in Binary Options.
- Time Decay
The rate of time decay of extrinsic value is exponential. It is not linear and so different types of options decay with different rates. For example, out-of-the-money options have a decay rate that at the beginning is fast, but slow down later on, and stays slow until expiration. At-the-money options, on the other hand, have a decay rate that is slower at the start, and faster towards expiry.
- Options type or Moneyness
There are three basic options moneyness or types: At the money, In the money, and Out of the money. Each of these types have differing extrinsic value for options.
Prominently, in-the-money options are known to have extrinsic value combined with intrinsic value, to give the option’s total value. Out-of-the-money options, however, only have extrinsic value; they do not have intrinsic value.