Intrinsic value versus extrinsic value

Any option premium splits cleanly into two components, and the split is the most useful decomposition in the whole subject.

Intrinsic value is what the contract would be worth if it expired this instant. For a call it is the underlying price minus the strike, floored at zero. For a put it is the strike minus the underlying price, floored at zero. It is a fact about the present, computable with no model and no assumptions.

Extrinsic value is the remainder, and it is the interesting part. It is sometimes called time value, but that name is misleading because it depends on volatility as much as on time. Extrinsic value is what the market charges for uncertainty, and it is the component that decays. At expiry it is exactly zero — every option, without exception, is worth precisely its intrinsic value at the end.

Holding the split in mind resolves a lot of confusion. A contract whose premium is entirely extrinsic has nothing to fall back on. A contract deep in the money is mostly intrinsic and behaves almost like the underlying itself. And a position can lose money while the underlying moves in its favour if the extrinsic component shrinks faster than the intrinsic component grows — the subject of lesson 17.