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Optionetics Trading Education Center
Intrinsic Value and Time Value
ATM and OTM options don't have any intrinsic value because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration. The intrinsic value of an option is not dependent on the time left until expiration. It is simply an option's minimum value; it tells you the minimum amount an option is worth. Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time. In other words, the time value of an option is directly related to how much time an option has until expiration. The more time an option has until expiration, the greater the option's chance of ending up in-the-money. Time value has a snowball effect. If you have ever bought options, you may have noticed that at a certain point close to expiration, the market seems to stop moving anywhere. That's because option prices are exponential-the closer you get to expiration, the more money you're going to lose if the market doesn't move. On the expiration day, all an option is worth is its intrinsic value. It's either in-the-money, or it isn't. Example: Let's use the table below to calculate the intrinsic value and time value of a few call options.
If the current market price of IBM is 106, use the table to calculate the intrinsic value and time value of a few call option premiums.
With the price of IBM at 106, a January 110 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 113 in order for the trade to breakeven (110 + 3 = 113). If you were to buy a January 95 call and pay 13 ½ for it, IBM would only have to be at 108 ½ in order to break even (95 + 13 ½ = 108 ½). 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 create the delta of an option. Understanding the delta is the key to creating delta neutral strategies-one of the main approaches to nondirectional 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. << Previous Next >> |
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