Stock Option Intrinsic Value and Time Value

Intrinsic value and time value are two of the primary determinants of an option's price. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. The following equations will allow you to calculate the intrinsic value of call and put options:

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.

1. Strike Price = 100
   Intrinsic value = Underlying price - Strike price = $106 - $100 = $6
   Time value = Call premium - Intrinsic value = $ 7 1/2 - $6 = $ 1 1/2

2. Strike Price = 105
   Intrinsic value = Underlying price - Strike price = $106 - $105 = $1
   Time value = Call premium - Intrinsic value = $3 7/8 - $1 = $2 7/8

3. Strike Price = 110
   Intrinsic value = Underlying price - Strike price = $106 - $110 = - $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.

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 1/2 for it, IBM would only have to be at 108 1/2 in order to break even (95 + 13 1/2 = 108 1/2). 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 non-directional trading strategies, which is one of the main approaches to the Trading Concepts option strategies. 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.