Intrinsic Value and Time Value
An option is like any other product in terms of price. The more valuable it appears to consumers, the more they will be willing to pay for it. What makes an option valuable is whether and to what extent it is in or out of the money, and how much time is available for the price of the underlying stock to change. An option that is just in the money but that expires in two days might be worth less than an option that is out of the money but expires in 60 days.
Price is a measure of value, and the price of an option is its premium. The value of a premium is made up of two components: intrinsic value and time value.
premium = intrinsic value + time value
Intrinsic value is the amount per share that the holder of an option stands to gain by exercising it. Stated another way, it is the extent to which the option is in the money. If the market price of a stock is $40 and the strike price of a call option is $30, the intrinsic value of the option is the difference: $10. If the market price is $20 with a $30 strike price, the option is out of the money and the intrinsic value of the option is zero.
- • For in-the-money call options: intrinsic value = market price – strike price
- • For out-of-the-money call options: intrinsic value = $0
- • For at-the-money call options: intrinsic
