Understanding Intrinsic Value
Understanding intrinsic value is very important to understanding the movements in option and spread prices over time writes Sam Green.
Intrinsic value represents how far in the money a particular option is; for call options, each cent the underlying share price is above the call’s strike is one cent of intrinsic value. For put options, each cent the underlying price is below the strike price is once cent of intrinsic value. Any residual value, i.e. the cost of the option minus intrinsic value, represents the amount of time value left in the trade. This time value will slowly decline as the option approaches expiry.
“In the Money”
Only trades that are “in the money” hold intrinsic value.
A call option is considered “in the money” if the share price is above the strike price. A put option is considered “in the money” if the share price is below the strike price of the option. When an option is “in the money”, it has “intrinsic value”. For call options, intrinsic value is the price of the underlying index or share, minus the strike price of the call. For put options, intrinsic value is the strike price of the put, minus the price of the underlying share or index.
It should be noted here that no matter what investment strategy is used, investors should seek professional financial advice for further information about those strategies and the stocks they are interested in.
Now let’s look at how it works.
If CBA on expiry is trading at $82.50 and you own a call option with a strike price of $82.00 your call option is “in the money” and has an “intrinsic value of $0.50. If the option price in the open market before expiry is valued at $0.70 the $0.20 difference is known as time value. On expiry one of two thing can happen if you own that call option:
- Sell the call option on the open market as it has value because of its “intrinsic value”, the selling price will be determined by the open market.
- The holder of the option can exercise their right and buy the stock at $82.00 “the strike price”.
If BHP on expiry is trading at $35.30 and you own a put option with a strike price of $36.00 your put option is “in the money” and has an “intrinsic value of $0.70. If the option price in the open market is valued at $1.00 the $0.30 difference is known as time value. On expiry one of two thing can happen if you own that put option:
- Being sell the put option on the open market as it has value because of its “intrinsic value”, the selling price will be determined by the open market.
- The holder of the option can exercise their right and sell the stock at $36.00 “the strike price” when the share is trading at $35.30.
“At the Money” or “Out of the Money”
Trades that are “At the Money” or “Out of the Money” hold no intrinsic value. That is not to say that the options are worthless. Rather, any value left in the option is purely time value, reflecting the probability of the underlying index or share price moving back into the money between now and the option’s expiry date. Therefore, this time value will decline over time as the option approached expiry. “At the Money” or “Out of the Money” options at expiry point will hold no value as both the intrinsic and time value components will be zero.
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