Intrinsic value and time value of option: Options contract is a unique derivative instrument that lets its buyers bet on the price of an underlying asset by paying only a fraction of the amount called the premium. This premium of an options contract is arrived at with the help of two components: Intrinsic value and time value. Knowledge about these components helps us get a better understanding of the pricing system of options

In the article, we understand what is Intrinsic value and time value of option and see how these values are calculated.

What are options contracts?

An options contract is an agreement between two parties to buy and sell an underlying asset at a predetermined price on or before the expiration date of the contract.

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While entering an options contract, the buyer of the options contract has the right but not an obligation to execute the options on the day of the expiry. On the other hand, the sellers are obligated to honour the contract if buyers choose to exercise their rights.

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For receiving the benefit of a choice (to exercise or not to exercise), the buyer of the options has to pay an amount to the seller of the options contract called the Premium.

The options contract is further divided into two types: Call option and Put option

Call Option

A call option is an agreement between the buyer and seller of the contract to purchase the underlying asset at a predetermined price, on or before the expiration date. Here, the buyer of the options contract has the right and not an obligation to exercise the contract but the seller is obligated to honor the contract.

Put Option

A put option is an agreement between the buyer and seller of the contract to sell the underlying asset at a predetermined price, on or before the expiration date. Here, the buyer of the options contract has the right and not an obligation to exercise the contract but the seller is obligated to honor the contract.

Terminologies you need to know

Here are a few essential terminologies that are often used in Options trading:

Spot Price

It is the market price of the security at which it can be immediately bought and sold. It serves as the basis for the option contract pricing.

Strike Price

Also known as exercise price, is the pre-determined price at which the buyer and seller of an option agree to execute the contract.

In-The-Money (ITM) Option

In-the-money option refers to the contracts that would give the options buyers a positive cash flow if it were to be exercised immediately.

A call option contract is said to be in-the-money when the spot price is greater than the strike price. And, a put option contract is said to be in-the-money when the spot price is lesser than the strike price.

At-The-Money (ATM) Option

At-the-money option refers to the contracts that would lead to a zero cash flow if they were to be exercised immediately. Here, both the call option and put option holders are at-the-money when the strike price equals the spot price.

Out-Of-Money (OTM) Option

Out-of-money option refers to the contracts that would give the options buyers a negative cash flow if they were to be exercised immediately.

A call option contract is said to be out-of-money when the spot price is lesser than the strike price. And, a put option contract is said to be out-of-money when the spot price is greater than the strike price.

What is the Intrinsic value and time value of option?

The premium that you pay for an options contract of a particular strike price comprises of two components: Intrinsic value and time value. Thus the formula to calculate the option premium will be:

Option Premium= Intrinsic Value+ Time Value

The intrinsic value is based on the difference between the spot price and the strike price. The time value of an options contract is based on the time left for the expiry of the options contract. Let us now understand each of these components in detail.

Intrinsic value

Intrinsic value represents the immediate worth of an option if it were to be exercised

immediately. It is the amount realized by the option buyer before deducting the premium paid.

Since the option buyers would not execute their options contracts if it is not beneficial to them, the intrinsic value of the options cannot be negative. Due to this, only in-the money options contracts have intrinsic value.

The intrinsic value for a call option is the excess of the spot price over the strike price. Similarly, the intrinsic value of a put option would be the excess of the strike price over the spot price.

Following are the formulas to calculate the intrinsic values of an option:

Call Option Intrinsic Value = [(Current Market Price – Strike Price), 0] whichever is higher

Put Option Intrinsic Value = [(Strike Price – Current Market Price), 0] whichever is higher

Example for calculating Intrinsic value

Intrinsic value calculation

The above image is the option chain of Nifty50 with an expiration date of 25 May 2023

Let us calculate the intrinsic value for ITM, ATM, and OTM strike prices when Nifty50 is trading in the range of 18300.

The intrinsic value of a call option

Call Option Intrinsic Value = [(Current Market Price – Strike Price), 0] whichever is higher

  • Intrinsic value at the strike price of 18,200

Intrinsic value= [(18300-18200), 0] whichever is higher

Intrinsic value= 100

  • Intrinsic value at the strike price of 18,300

Intrinsic value= [(18,300 -18,300), 0] whichever is higher

Intrinsic value= 0

  • Intrinsic value at the strike price of 18,400

Intrinsic value= [(18,300 -18,400), 0] whichever is higher

Intrinsic value= 0

The intrinsic value of a put option

Put Option Intrinsic Value = [(Strike Price – Current Market Price), 0] whichever is higher

  • Intrinsic value at the strike price of 18,200

Intrinsic value= [(18,200-18,300), 0] whichever is higher

Intrinsic value= 0

  • Intrinsic value at the strike price of 18,300

Intrinsic value= [(18,300-18,300), 0] whichever is higher

Intrinsic value= 0

  • Intrinsic value at the strike price of 18,400

Intrinsic value= [(18,400-18,300), 0] whichever is higher

Intrinsic value= 100

Time value

The time value of options is the additional premium an option buyer is willing to pay over the intrinsic value based on the probability of the contract expiring in-the-money before the expiration date.

The general perception of the time value of the option is that the options contract has a better chance of expiring in-the-money the further away it is from its expiration date. The time value of an options contract keeps decreasing the closer it approaches its expiration date as there is less time for the spot price to reach the strike price.

Following is the formula to calculate the time values of an option:

Time Value = Option Premium – Intrinsic Value

Example for calculating the Time value

Intrinsic value and time value of option - Time Value Calculation

The time value of a call option

Time Value = Option Premium – Intrinsic Value

  • Time value at the strike price of 18,200

Premium/LTP at the strike price of 18,200 is Rs.126.95 and the Intrinsic value is Rs.100 (based on the previous calculation)

Time Value= 126.95- 100

Time Value= 26.95

  • Time Value at the strike price of 18,300

Premium/LTP at the strike price of 18300 is Rs.62.90 and the Intrinsic value is Rs.0 (based on the previous calculation)

Time Value= 62.90- 0

Time Value=62.90

  • Time Value at the strike price of 18,300

Premium/LTP at the strike price of 18400 is Rs.24.55 and the Intrinsic value is Rs.0 (based on the previous calculation)

Time Value= 24.55- 0

Time Value= 24.55

The time value of a put option

Time Value = Option Premium – Intrinsic Value

  • Time value at the strike price of 18,200

Premium/LTP at the strike price of 18,200 is Rs.26.30 and the Intrinsic value is Rs.0 (based on the previous calculation)

Time Value= 26.30- 0

Time Value= 26.30

  • Time Value at the strike price of 18,300

Premium/LTP at the strike price of 18300 is Rs.61.15 and the Intrinsic value is Rs.0 (based on the previous calculation)

Time Value= 61.15- 0

Time Value= 61.15

  • Time Value at the strike price of 18,300

Premium/LTP at the strike price of 18400 is Rs.122.80 and the Intrinsic value is Rs.100 (based on the previous calculation)

Time Value= 122.80- 100

Time Value= 22.80

In Closing

In this article, we discussed what is an options contract, its basic terminologies, and the Intrinsic value and time value of option.

Understanding the intrinsic value and time value of options is crucial for options traders because it helps you choose the best strategy to employ and manage your risk, both of which raise the likelihood that you will be successful in options trading.

Written By – Aaron Vas

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