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The price of an options can be broken down into two parts: extrinsic value and intrinsic value.
Intrinsic value is the portion of the option that can be realised if the option is exercised. Therefore, only in-the-money options have intrinsic value.
Consider the following example:
Underlying: Microsoft
Underlying Price: MSFT $30
Type: Call Option (American)
Strike Price: $25
Expiry Date: 30th September
Now, imagine that this particular call option is currently trading at $7. How can we better understand this price?
Well, the first part we can look at is it's Intrinsic Value: the value of the option that, if exercised, would result in a profit. We know that the call option's strike price is $25 and with Microsoft trading at $30 it is already worth at least $5.
This is what's known as Intrinsic value - the value that can be made by exercising the option.
When an option is trading at more than the intrinsic value, the difference is known as Extrinsic Value, or more commonly known as Time Value.
Looking at the previous example, we have already determined that the option is worth at least $5 - its Intrinsic Value. However, it is actually trading at $7.
The remaining $2 is called Extrinsic Value and represents the markets view of how far the underlying could trade as high as by the time the contract expires.
Sometimes an option can have 0 Intrinsic Value but can still be worth something in the market. Why?
This is because traders believe that there is still some chance that the underlying could trade in a favorable direction, which would make the option profitable.
An option that has 0 Intrinsic Value is said to be out-of-the-money, i.e. if your were long (you bought) this call option and you exercised it, you would lose money by being assigned Microsoft shares at the exercise price $37, which are actually worth only $36 on the open market, leaving you with a loss of $1.
So, the call option has zero Intrinsic Value. Yet it's price in the market is $1.75. Does this mean that the option is over valued? Not really. It simply means that because the option still has 6 months until expiry, there is still plenty of time for the option to exceed the exercise hurdle of $37.
If the option expired tomorrow, it would have almost zero Extrinsic Value and zero Intrinsic Value - therefore being considered worthless. This is because the call option only has one day left for it to trade higher than $37 to give the trader a chance at making money from it.
However, because the option doesn't expire for another 6 months, there are approximately 120 days (or 120 chances) that Microsoft has to trade another dollar higher and therefore turn this option into an in-the-money option.
Comments (19)
Peter
May 17th, 2010 at 9:45pm
Yes.
vinay
May 17th, 2010 at 6:39am
can u tell that it that the option value (intinsic + time value ) is actually the premium that the buyer would pay???????????
Peter
February 15th, 2010 at 3:43am
Almost. If you have bought a call option and choose to exercise it, then yes, you now buy the stock at the "strike price" of the option - not the premium. The premium is the price you pay for the contract when you enter the position...and this premium is received by the seller of the option.
So, let's say you buy a $25 (strike price) call option. The stock trades to $27. At this point you decide to "exercise" the option. What happens is that you are assigned stock in your account at a purchase price of $25 (thanks to the option seller) while the stock is currently trading at $27.
mark
February 14th, 2010 at 8:23am
So, when I exercise an option that is in the money...above it's strike price....I actually purchase the underlying stock shares at my original options premuim purchase price? When options are exercised...they actually are converted to stock shares at the current stock value?
Peter
February 14th, 2010 at 5:57am
Hi Mark, for a call option at expiration, the stock has to be above the strike the option to be profitable. However, options are tradable like many other assets on the market...that is, you can buy a call option for 20 cents while the stock is below the strike and then sell it the next day for 25 cents (if the market has move in your favor).
Mark
February 9th, 2010 at 6:35pm
New to options! Does an option have to be above its strike price in order to make a profit? Also, if you sell an option before expiration, but below the strike price do you lose your total investment or just part of it as long as the price of the stock is above where you bought it. I am not sure how you make your money in options?
Peter
September 12th, 2009 at 7:30am
Correct...the price shown in the market is 2 but the premium you pay is $200.
newbie
September 11th, 2009 at 11:37am
srry m new 2. if i buy an option for say 2.00, if it's for 100 shares the value is 200.00 . Then premium price is also 200$ right?
Peter
August 17th, 2009 at 6:51am
Hi Adnan,
1) For a call option the intrinsic value is underlying price - strike price. In your example, the instrinsic value is $8 ($33 - $25).
2) Time Value depends on the volatility. See my spreadsheet under the Pricing link above for an idea how option pricing works.
3) Option value = intrinsic value + time value. If you buy an option you pay the value (i.e. premium) to the option seller.
adnan jahangir
August 14th, 2009 at 1:50am
Me want to know the exact basics. my example is
If i bought option of 20$ with strike price of 25$ for 3 months at the date of expiry underlying asset is having price of 33$ what are
1) intrinsic value and to whom it will go to holder of option or writer.
2) what is time value to whom it will go holder or writer
3) what is the option value and to whom it belong writer or holder.
please explain those in call option .hopping that my question is complete .
Peter
July 10th, 2009 at 7:34am
Hi Thomnel,
You would pay $200 for the option and your maximum loss would therefore be $200.
thomnel53
July 5th, 2009 at 3:43pm
o.k. so if you buy an option for say 2.00, if it's for 100 shares the value is 200.00 right. Do you pay 2.00 or 200.00 for it, and if it tanks do you only lose the 2.00 or what? sorry i'm new.
Peter
May 11th, 2009 at 6:28pm
Hi Joe, yes, $37 in the above represents the exercise price. I used $30 and $36 to represent two examples of MSFT share prices.
Joe
May 11th, 2009 at 1:28pm
Hi, I dont understand with the example given in the intrinsic value, it is said that if your were long (bought) this call option and you exercised it, you would lose money by being assigned Microsoft shares at the exercise price $37, which are actually worth only $36 on the open market.
My question is whether the exercise price of $37 is from the Microsoft share which is $30 and $7 from trading value. if yes, how about $36? where the sum ($36) comes from? thanks. I hope you understand what i am trying to ask :)
lincoln
March 22nd, 2009 at 11:36am
Excellent!!! using simple examples to explain difficult market situation,its is very helpful. thanks
David
March 17th, 2009 at 12:52pm
Thank you, Very helpfull. Big eye opener actually.
Abdul Raoof
March 4th, 2009 at 10:05am
The explanation given is highly useful and very simple to understand
Admin
December 9th, 2008 at 3:40am
Hi HH,
It depends. You can download my spreadsheet:
http://www.optiontradingtips.com/pricing/free-spreadsheet.html
or view an online calculator like:
http://www.option-price.com
HH
December 8th, 2008 at 1:55pm
Hello,
what is the fair value of a call option? is it what you refered to above?
Thanks
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