5.1.6.3. Intrinsic Value and Time Value
An option is like any other product in terms of price. If it appears more valuable to consumers, they will be willing to pay more 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 which 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
Remember that a put option is in the money when the underlying stock has gone down in price relative to the strike price. Using the same example, if the strike price of a put option is $30 and the current market price of the underlying stock is $20, the option is in the money and the intrinsic value is $10. If the stock is selling at