Option Value - Understanding Premium
When you look at an option chain it can be confusing to know what the option bid/ask prices really mean and how they relate to the strike and stock price.
Before going deep into the mathematics of option pricing, I'm going to help you understand the bigger pieces that make up an option price.
The price of an option can be represented by two components; Intrinsic Value and Extrinsic Value. These values combined make up the option's price. Take a look at these two example diagrams, I will reference these below.
Intrinsic Value
Intrinsic value is the amount of the option price that can be realized if the option is exercised. Only in-the-money options have intrinsic value.
Consider a $25 strike call option on a stock that is trading at $27.
Now, imagine that this particular call option is currently trading at $2.50. How can we better understand the meaning of this price?
Well, the first part we can look at is the option's exercise value; that is, if the option were exercised now, what would be the resulting profit.
If this option were exercised, the buyer of the option would take delivery of the shares with a purchase price of $25. The shares, however, are actually trading at $27, which means an immediate profit of $2.
This $2 is what is referred to as the Intrinsic Value; the value able to be realized if the option is exercised.
With the option priced at $2.50, we have $2 of Intrinsic Value. The remaining $0.50 is called Extrinsic Value.
Extrinsic Value
When the price of an option is trading at more than it's Intrinsic Value, the difference in price is what is called Extrinsic Value, or more commonly known as Time Value.
In our example, we determined that the option is intrinsically worth $2, but given that it is trading at a price of $2.50 means the $0.50 difference is the option's Extrinsic Value.
This $0.50 in time value represents the opportunity that the option still has remaining before it expires. More time means there is more chance that the stock will move in favor of the option buyer.
Options that are in-the-money or at-the-money will have premiums comprised of both intrinsic and extrinsic value. The amount of extrinsic value present in the price will depend on the time remaining until expiration and the implied volatility of the option.
Deep in-the-money options will have close to zero extrinsic value. And an out-of-the-money option price will 100% extrinsic value and 0 intrinsic value.
How to calculate Extrinsic Value?
Calculating the time value present in an option isn't as simple as calculating the intrinsic value; you will need the help of an option pricing model for that. If the option has a European exercise style then a Black and Scholes model will do and if the option has an American Style then you can look at a Binomial Model.
56 Comments
Peter June 12th, 2011 at 7:32am
Hi Fiona, if the option value was less than its intrinsic value then buyers would buy the option and immediately exercise the option into the underlying for a risk-free profit. This would happen until there was no longer any opportunity.
Option buyers can still make money buying options when they are priced more than their intrinsic value i.e. by buying a call option and the underlying price increases.
Fiona June 10th, 2011 at 3:03pm
Hello,
In my book, it said "the value of option must be equal at least intrinsic value" . I don't really get that . I thought value of option = time value + intrinsic value = option premium. If the value of option (option premium) need to be equal at least intrinsic value then how could option's buyer make profit?
Shen May 5th, 2011 at 11:35am
Thanks pete, it's really helpful. I finally understood what my lecturer had been talking.
Peter March 30th, 2011 at 6:59am
There isn't any relationship between intrinsic value and volatility - volatility is only relevant when it comes to extrinsic value.
geeke March 30th, 2011 at 6:32am
what is the relation between intrinsic value and volatility
Peter November 14th, 2010 at 3:59pm
Absolutely not! I wrote the content myself from what I have learned and experienced being in the options industry. Would you mind please providing a page or two from Investopedia as examples of your claim?
arjun November 14th, 2010 at 5:14am
its look like that content is copied from investopedia
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.
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