The second component is called Extrinsic Value. An option’s extrinsic value is the portion of the option’s price that exceeds its intrinsic value. Let’s take an example to better understand it:
In the image above, TSLA is trading at a share price of $836.41 and we can see a call option with a strike price of $800. So as you can guess, the call option has an intrinsic value of $36.41, which is the benefit or real value it can provide to its owner. Why? Because the 800 call can be used to buy shares at $800/share, which is $36.41 below the current share price of $836.41.
But as we can see, the actual option price is $94.10, which is much higher than its intrinsic value. Here, the portion of the TSLA option’s price that is above its intrinsic value of $36.41 is called its extrinsic value.
We can understand an option’s extrinsic value as the part of its price associated with the potential for the option to become more valuable before its expiration. That is why the extrinsic value is sometimes referred to as “time value.”
As time passes, extrinsic value is lost, leaving only intrinsic value at expiration.
So in the case of this TSLA option, it has a 30-day expiration period. And going by TSLA’s volatility, we all know it can move around a lot in a 30-day period. So if TSLA ends up climbing to $900 by the option’s expiration date, its intrinsic value will increase to $100, which is why it makes sense that its current extrinsic value is $57.69.
This brings us to another point: options with a longer-term expiration date will trade with higher levels of extrinsic value compared to those with shorter expiration dates, because of the simple reason that with more time until expiry, stocks have larger potential movements.