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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 an intrinsic component 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. It is also referred to as extrinsic value and 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 price seems to stop moving anywhere. That's because the time component of price decays exponentially; the closer you get to expiration the more a move in the security is needed to impact price. On 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.

PRICE OF IBM = 81
CALL STRIKE PRICE	JAN	APRIL	JULY
75	6 3/8	7	8
80	2	3 7/8	4
85	3/8	1 9/16	2

If the current market price of IBM is 81, use the table to calculate the intrinsic value and time value for the April call option premiums.

• Strike Price = 75
  Intrinsic value = Underlying price - Strike price = $81 - $75 = $6
  Time value = Call premium - Intrinsic value = $ 7 - $6 = $ 1
• Strike Price = 80
  Intrinsic value = Underlying price - Strike price = $81 - $80 = $1
  Time value = Call premium - Intrinsic value = $3 7/8 - $1 = $2 7/8
• Strike Price = 85
  Intrinsic value = Underlying price - Strike price = $81 - $85 = - $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.

PRICE OF IBM = 81
STRIKE	JAN	Intrinsic Value	Time Value
65	17	16	1
70	13	11	2
75	10	6	4
80	6	1	5
85	3	0	3

With the price of IBM at 81, a January 85 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 83 in order for the trade to breakeven (80 + 3 = 83). If you were to buy a January 65 call and pay $17 for it, IBM would only have to be at $82 in order to break even (65 + 17 = 82). 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 describe the delta of an option. Understanding delta is the key to creating delta neutral strategies, one of the main approaches to non-directional 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.