Basic Options Concepts: 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:

Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price Time Value = Call Premium - Intrinsic Value
Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current Price Time Value = Put Premium - Intrinsic 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.



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How is Option Priced?

There are 6 factors that affect option's price.  Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors.  Most of the time, for each level of strike price, an option's price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

Since option's buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.  

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option's position.

Example:  

Increase in Implied Volatility (IV) would increase option's price (both calls & puts), assuming other factors unchanged.  Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

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