Because intrinsic value is the amount an option is in-the-money, at-the-money and out-of-the-money options do not have any intrinsic value. The one and only variable that will influence how much intrinsic value your option has is the underlying stock price. Suppose you currently own an in-the-money call option. As the stock price rises and your call moves deeper in-the-money it will accrue more IV. Conversely, as the stock price decreases your option will become less in-the-money (and eventually out-of-the-money) causing it to lose IV. At expiration the premium of an in-the-money option is equal to its intrinsic value.

Extrinsic Value:

Extrinsic value or EV is the amount of money an option is worth over and above the IV. EV can be thought of as the amount of money option buyers pay for time and implied volatility. EV is often referred to as time value. Generally, the more time an option has to expiration, the more EV it possesses. The formula to calculate EV is: premium minus intrinsic value. Let's compare a one-month 45 strike call option to a six- month 45 strike call option on a $50 stock. Because both options are $5 in-the-money they possess the exact same amount of intrinsic value. However, that doesn't mean they will be worth the same amount. Since the six-month option has more time to expiration it will invariably posses more extrinsic value. Let's check:

Stock XYZ @ $50
1 month 45 call premium = $6.50
Intrinsic Value = 50 - 45 = $5.00
Extrinsic Value = 6.5 - 5 = $1.50

6 month 45 call premium = $11.00
Intrinsic Value = 50 - 45 = $5.00
Extrinsic Value = 11 - 5 = $6.00

As you can see the six-month option has four times as much extrinsic value ($6 vs. $1.50). Implied volatility is another variable that influences the amount of extrinsic value that an option contains. If we were to compare two-similar options (same strike price, same time to expiration, but different underlying stock), one trading at 100 percent implied volatility and the other trading at 25 percent implied volatility. Which do you think would contain more extrinsic value? If you said the option with 100 percent implied volatility you are correct! As implied volatility increases, options accrue extrinsic value, as implied volatility decreases, options lose extrinsic value.

Hopefully you know by now that options are decaying assets and lose money as time passes. It is crucial to understand the differences between intrinsic and extrinsic value because it aids in measuring exactly how much value your option will lose due to time decay. Options don't lose all of their value at expiration; rather they lose all of their extrinsic value. Let's look at a covered call example to illustrate:

Suppose you buy a stock at $50 and sell an in-the-money 45 strike call for $6. Some traders may think that they can make $6 of profit in this trade since that is the amount of premium they received for selling the call option. That would be an incorrect assumption! The 45 strike call option possesses $5 of intrinsic and only $1 of extrinsic value. As a result, your max profit is only $1, not $6! Assuming the stock stays at $50 or above, only the $1 of extrinsic value will erode out of the option premium as time passes, not the $5 of intrinsic value.

Although we used a basic covered call in our example, differentiating between intrinsic and extrinsic value is important in any type of options trade. Making it a priority to grasp the nuances of intrinsic and extrinsic value will assuredly help in understanding more advanced option strategies.