Intrinsic Value & Time Value
Many components go into determining the value of an option. They are Stock Price, Intrinsic Value, Time Value, Volatility, Interest Rates and Dividends. All of these components are calculated together and the result is the Premium. The Premium is the price paid when there is a sale of an option; it is the value of an option. The premium is very important for an options trader. What goes into the pricing of the Premium is important to be a savvy option trader but right now we don’t have to concentrate on all components. But there are two components in the chemistry of the option’s value (the Premium) that are very important to understand now because they will be a major part of decision making when buying or selling options. The two components are part of the option-lingo, they are called Intrinsic Value and Time Value.
Intrinsic Value
Whenever an option is In-the-money, its premium includes intrinsic value. When the Stock Price is above the Strike Price, the option is said to be In-the-Money. Only In-the-Money options have intrinsic value. Example, if the stock price is $20 and you bought an option with the Strike price of $18, you are In-the-Money by $2. You have the right to buy a $20 stock at $18. The intrinsic value is real value. If you did buy the stock at $18, you can sell the stock 2 minutes later for $20. Intrinsic value is important. Look back at my real estate option under “Educational”, go to “What is an Option? (Call)“ and review. I bought an option to buy Mary’s house. I had a contract to buy with a Strike Price of $60,000. At expiration the house was worth $165,000. My option had $105,000 in intrinsic value, real value. As soon as I buy that house my net worth goes up $105,000. Whether its a stock option or the option I had to buy Mary’s house, intrinsic value has real value. All other components of an option can change, if the Strike Price is lower than the value of the stock (or house), the intrinsic value will be the difference between the Strike Price and the Stock Price, you are In-the-Money. If the stocks volatility goes through the roof, interest rates change, the stock adds a dividend or your option has very little time left, the intrinsic value will stay the difference between the Strike Price and the Stock Price with an In-the-Money option. The intrinsic value will only change if the distance between the Strike Price and the Stock Price changes with an In-the-Money option. Meaning the stock price changes. If the stock in the example above goes from $20 to $25 and the Strike Price is still $18, the intrinsic value goes from $2 to $7, the difference between the Strike Price and the Stock Price. If the price of Mary’s house goes from $165,000 to $150,000 I would lose $15,000 in intrinsic value. It would go from $105,000 in intrinsic value to $90,000 in intrinsic value because my Strike Price (buying price) of the house is constant at $60,000.
Stock Value $20 with Strike Price $18, Intrinsic Value is $2
House Value $165,000 with Buying Price $60,000, Intrinsic value is $105,000
Time Value
To help understand Intrinsic Value, I hope you went back to read the page called, “What is an Option? (Call).” And while you were there, you also concentrated on the importance of the Time Value to my real estate option. I feel the real estate example is a great way to capture and absorb the concepts if Intrinsic Value and Time value. When Mary wanted to buy me out of my option contract there was still over a years remaining before the expiration of our deal. The little over a year of time remaining to our contract had value because of the potential of the house raising in value in that remaining time. This concept of “Time Value” is extremely important to understand when trading options, especially when selling options. Understanding how the time value decays with the passage of time is my most powerful weapon with my favorite strategy, selling Naked Calls.
The evaporation of Time Value accelerates as expiration comes closer. For anyone in a Long position, time is the enemy. If you buy an option, this is a long position. Let’s say you buy an option on Facebook (FB). The price of the stock is $100 per share and you “Buy to Open” 10 contracts that will expire in 2 months with the Strike Price of $110. Your premium is $1.75. You pay $1750 and you have the right to buy 1000 shares of FB any time in the next 2 months for $110. There is no Intrinsic Value because the option is not In-the-Money. There will be intrinsic Value only if the price of the stock goes above $110. If the price of FB stays the same, the $1.75 premium (Time Value) will decay and this Time Decay will accelerate more and more each day as expiration comes closer.
For anyone in a Short position, the passage of time is on your side. When you short an option, you are selling an option. If you buy that option back, you want it to be worth less. The passage of time reduces the price of the option. If you sell an option for $1.75, and with the passage of time the premium goes down to $.80, you are making money. You sold and received $1750 on 10 contracts and you pay $.80 or $800 to get out of the contract, your profit is $950.
To really understand why this is so important, you must understand why traders trade option. Continue reading with the sections “Time Decay“, “Buying Call Options“ and “Selling Call Options.”