WHY EXTRINSIC VALUE ISN'T TIME VALUE - Singapore Forex Trading, Singapore Forex Academy, Singapore Forex Association

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WHY EXTRINSIC VALUE ISN'T TIME VALUE

Extrinsic Value has been commonly known as "Time Value" because extrinsic value is generally higher for options with longer date to expiration. This is again to justify the additional risk the writer of the option is undertaking. The longer the time to expiration, the longer the exposure to risk to the options writer. However, even though the amount of "time" left in a stock options contract is a major determinant of Extrinsic Value, extrinsic value is NOT only determined by time. 

Extrinsic value answers the question of "How much money justifies the risk the writer of the option is undertaking". This risk is defined in options trading using 4 different criteria and factored into a mathematical options pricing models such as the Black-Scholes Model. Indeed, when someone writes an option, that person's risk is not only limited to how long the person is exposed to the risk of being assigned but also a variety of other risks. 

The 4 factors that come together to determine extrinsic value are: 


1. Time left to expiration (Theta

2. Changes in interest rate (Rho

3. Volatility of the underlying stock (Vega

4. Dividends of the underlying stock 

As you can see above, time left to expiration is merely one factor taken into consideration when coming with the extrinsic value of a stock option. As such, labelling extrinsic value as "Time Value" is not entirely accurate. However, it must still be acknowledged that out of the four factors, time to expiration and volatility have the greatest influence on extrinsic value while interest rates and dividends are relatively insignificant.