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Intrinsic Value and Time Value - Page .. 1 .. 2
Example: Let's use the table below to calculate the intrinsic value and time value of a few call options.
| PRICE OF IBM = 81 |
CALL STRIKE PRICE
75
80
85
|
JAN
6 3/8
2
3/8
|
APRIL
7
3 7/8
1 9/16
|
JULY
8
4
2
|
If the current market price of IBM is 81, use the table to calculate the intrinsic value and time value for the April call option premiums.
- Strike Price = 75
Intrinsic value = Underlying price - Strike price = $81 - $75 = $6
Time value = Call premium - Intrinsic value = $ 7 - $6 = $ 1
- Strike Price = 80
Intrinsic value = Underlying price - Strike price = $81 - $80 = $1
Time value = Call premium - Intrinsic value = $3 7/8 - $1 = $2 7/8
- Strike Price = 85
Intrinsic value = Underlying price - Strike price = $81 - $85 = - $4 = Zero Intrinsic Value
Time value = Call premium - Intrinsic value = $1 9/16 - $0 = $1 9/16 = All Time Value
The intrinsic value of an option is the same regardless of how much time is left until expiration. However, since theoretically an option with 3 months till expiration has a better chance of ending up in-the-money than an option expiring in the present month, it is worth more because of the time value component. That's why an OTM option consists of nothing but time value and the more out-of-the-money an option is, the less it costs (i.e. OTM options are cheap, and get even cheaper further out). To many traders, this looks good because of the inexpensive price one has to lay out in order to buy such an option. However, the probability that an extremely OTM option will turn profitable is really quite slim. The following table helps to demonstrate the chance an option has of turning a profit by expiration.
| PRICE OF IBM = 81 |
STRIKE
65
70
75
80
85
|
JAN
17
13
10
6
3
|
Intrinsic Value
16
11
6
1
0
|
Time Value
1
2
4
5
3
|
With the price of IBM at 81, a January 85 call would cost $3. The breakeven of a long call is equal to the strike price plus the option premium. In this case, IBM would have to be at 83 in order for the trade to breakeven (80 + 3 = 83). If you were to buy a January 65 call and pay $17 for it, IBM would only have to be at $82 in order to break even (65 + 17 = 82). As you can see, the further out an OTM option is, the less chance it has of turning a profit.
The deeper in-the-money an option is, the less time value and more intrinsic value it has. That's because the option has more real value and you pay less for time. Therefore, the option moves more like the underlying asset. This very important concept helps to describe the delta of an option. Understanding delta is the key to creating delta neutral strategies, one of the main approaches to non-directional Optionetics trading. One of the reasons it's important to know the minimum value of an option is to confirm how much real value and how much time value you are paying for in a premium. Since you can exercise an American style call or put anytime you want, its price should not be less than its intrinsic value. If an option's price is less than its exercise value, an investor could buy the call and exercise it, making a guaranteed arbitrage profit before commissions. |
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