Intrinsic Value and Time Value
Option prices are commonly known as the premium. It is composed of 2 elements, the Intrinsic Value & Time Value.
Option premium = Intrinsic Value + Time Value
Option intrinsic values is the amount that is in the money & it has a zero value for out of money option.
It can be calculated by subtracting the current stock price against the strike price of the option.
It is a very important value to find out as it is the portion of the option price that will not be lost due to passage of time. The intrinsic values will increase or decrease base on the fluctation on the underlying stock's price movement.
One the other hand,Time value is any amount by which the options premium exceed the option intrinsic value. It is also referred to as the extrinsic value. The time value of an option decreases as time passes until, at expiration, become zero.
Confused? Let’s take a quick look at below formulas on how to calculate intrinsic value and time value. Several examples are shown for you to have a better understanding of the concept.
Call Option
Intrinsic value = Current price of the underlying stock less Strike Price of the Call Option
Time value = Option premium less Intrinsic Value
Put Option
Intrinsic value = Strike Price of the Put Option less Current price of the underlying stock
Time value = Option premium less Intrinsic Value
An out of the money call option has no intrinsic value and is entirely make up of time value.
The table below shows the intrinsic value and time value, taken from a representative stock trading near $50, for strike price between $35 to $65.
From the above table, you are able to derive certain interesting facts:
1) Deep in the money option is composed mainly by intrinsic values with very little time value. Since you are paying less for time value, an in the money option’s premium moves more like the prices of the underlying stocks.
2) Time value reaches its peak when the strike price is at the money . That is because the at the money options has a 50:50 chance of moving in the money or out of the money.
3) Then option prices start to decline & get cheaper when you move further out of the money. That is because out of the money option is composed entirely by time value. The further out of the money an option get, the less chance it has of moving in the money by expiration. If the option did not move in the money by expiration, it is worthless.
Many inexperience traders see out of the money options as a great deal due to their inexpensive prices.
However, the probability that an extremely out of the money option will turn profitable is very slim.
On the expiration day, all an option is worth is its intrinsic value. It can only be either in the money or it is not.
Next go to Options Open Interest
Return from Intrinsic Value and Time Value to Option Basics
