Every option contract has a price, and the price consists of two components:

Option Price = Intrinsic Value + Extrinsic Value

***Note that the option price changes based on other Greeks and Volatility. In many cases, the price will be greater or less than the simple method of calculating.

An option's intrinsic value can be conceptualized as the value of being able to buy or sell shares at the option's strike price as opposed to the current price of the shares.

For example, if a stock is trading for $75, a call option with a strike price of $50 has $25 of intrinsic value. This is because the ability to purchase shares $25 below the market price should be worth at least $25.

On the other hand, with the stock at $75, a call option with a strike price of $75 has $0 of intrinsic value because exercising the call has no "real" value, as the investor can buy shares for $75 without using an option.

• In the Money = Strike Price < Current Price

  • • e.g. Current price is $45, you believe the price will rise and you purchase the $50 Strike

    • One week from now the price has risen to $75

    • 50 Strike < 75 = In the Money

    • Intrinsic Value = $25 ($75 current price - $50 strike price)

• Out of the Money = Current Price > Strike Price

  • • e.g. Current price is $45, price will rise and you purchase the $50 Strike

    • The $50 strike = Out of the Money

    • Strike Price > Current Price

At expiration, an option's price will only consist of intrinsic value. Therefore, an alternative definition of intrinsic value is what the option will be worth at expiration (if the stock price were at its current price).

An option's extrinsic value is the portion of an option's price that exceeds its intrinsic value. From the previous example, if the call option with a strike price of $75 is trading for $5, its extrinsic value is $5. This is because the option has no intrinsic value, which means any value it has is extrinsic.

Why would an option with no intrinsic value be worth anything? Well, there's a chance that the option ends up being valuable by the time it expires. An option's extrinsic value is essentially the price associated with the potential for an option to become more valuable before it expires.

At expiration, options with only extrinsic value will be worthless. So, an option's intrinsic value will always remain, but the extrinsic value will decrease as expiration approaches, as the option's real value becomes more certain. For the reasons mentioned here, extrinsic value is often referred to as an option's "time value."

Now that you've learned the very basics of an option's price components, let's walk through and visualize how they relate to call and put options.

Information taken from https://www.projectoption.com/intrinsic-extrinsic-value/