Intrinsic value and time value are two major determining factors of the value of an options contract.
An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right now. In other words: the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security.
An option’s time value is not as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset, as well as the amount of time until the option contract expires.
What Is the Intrinsic Value of an Option?
An investor who purchases an options contract may be buying the right, but not the obligation, to buy or sell the option’s underlying asset at an agreed-upon price, known as the strike price. Options are considered derivatives, because they are tied to the value of the underlying security. The contract allows the investor to purchase or sell a security at that strike price at any point up until the contract expires.
There are two main kinds of options: calls and puts. The purchaser of a call option buys the right to purchase the underlying asset at a given price until a particular date.
The buyer of a put option purchases the right to sell the underlying asset at a given price until a particular date.
Important terms: In the money, at the money, out of the money
An option is considered to be “in the money” if the investor could sell it at that moment for a profit. For a call option, that means that the price of the underlying asset is higher than the strike price specified in the options contract. For a put option to be in the money, the price of the underlying asset would be lower than the strike price in the contract.
If an option is “at the money,” the price of the underlying security is equal to the strike price in the contract, and it’s not considered profitable. If an option is “out of the money,” e.g. above the market price for a call option or below the market price for a put option, the contract is also not profitable.
If an option is not profitable when it expires, then it expires with no value, except for the premium. In those instances, the buyer takes a loss on the premium they paid to enter into the options contract, while the seller or writer of the contract collects the premium.
Recommended: Popular Options Trading Terminology to Know
Formula for the Intrinsic Value of an Options Contract
To calculate the intrinsic value of a call option:
Call Option Intrinsic Value=USC−CS
SC=Underlying Stock’s Current Price
CS=Call Strike Price
To calculate the intrinsic value of a put option:
Put Option Intrinsic Value=S-USC
SC=Underlying Stock’s Current Price
PS=Put Strike Price
Example of Intrinsic Value
Imagine that hypothetical XYZ stock is selling at $48.00. A call option for XYZ with a strike price of $40 would have an intrinsic value of $8.00 ($48 – $40 = $8). So in theory, the option holder could exercise the option to buy XYZ shares at $40, then immediately sell them for a $8.00 profit in the market. Another way to phrase it: The contract would be in the money at $8.
But what if the strike price is higher than the $48.00 market price of XYZ stock? Let’s say the call option strike is $50 ($48 – $50 = –$2.00. The option would be considered out of the money and worth zero, because the intrinsic value of an option can never be negative.
What if it’s a put option? In this scenario, with an underlying price of $48.00 for XYZ stock, a put option with a strike price of $44.00 would have an intrinsic value of zero ($44 – $48 = –$4.00), again because the value of an option cannot fall below zero.
But a put option with a strike price of $50 would be considered in the money, and have an intrinsic value of $2 ($50 – $48 = $2).
While intrinsic value as a term sounds all encompassing, it isn’t. Investors should remember when calculating options strategies that an option’s intrinsic value does not include the premium the investor has to pay in order to buy the options contract in the first place. To get a better sense of the profit of an options trade, it’s important to include that initial premium, along with any other trading commissions and fees charged by the broker.
What is the Time Value of an Option?
When an investor buys an option, they pay for the privilege in the form of a premium, or fee. When they do, that premium is typically based on the option’s intrinsic value, plus its extrinsic value. While higher volatility can result in higher premiums, time value plays a large role as well.The opportunity for an option to be profitable over time is, in essence, its time value.
The more time an investor in an options contract has, the better their chances of being able to exercise that option in the money, simply because the underlying security has a greater chance of moving in the desired direction. Longer time periods come with greater possibility for profit.
Conversely, as an options contract gets closer to expiring, its value goes down. The reason is that there is less time for the security underlying the options contract to make profitable moves.
One rule of thumb is that an option loses a third of its value during the first half of its life, and two-thirds during the second half: a phenomenon known as the time decay of options. It’s a critical concept for options investors because the closer the option gets to expiration, the more the underlying security must move to impact the price of the option.
The intrinsic value of the option plays a role in how fast the time value of an option decays. An in-the-money option faces less dramatic time decay, because the elimination of time value takes the overall value of the option to the level of its intrinsic value. But for an out-of-the-money option, time decay is more dramatic, since the option will be entirely worthless if it expires out of the money.
Formula for the Time Value of an Options Contract
Time Value=Option Price−Intrinsic Value
How Does Volatility Impact Time Value?
Another important factor that can impact time value is the volatility of the underlying asset.
Stocks with higher volatility typically have the potential for greater price movements — and thus the option has a higher probability of expiring in the money. That’s one reason why time value, as reflected by the option’s premium, is typically higher when the underlying asset is more volatile.
With stocks and other assets that have lower volatility and therefore are not expected to show big price fluctuations, the time value and the option premium is likely to be lower.
Volatility, as every investor knows, cuts both ways. It can help generate gains or lead to losses. Fortunately there are specific calculators that help estimate volatility and give options traders more insight.
Recommended: Implied Volatility: What It Is & What It’s Used for
How Can Intrinsic and Time Value Help Traders?
When calculating the value of the options contracts that they’re buying and selling, intrinsic value and time value can be vital. While the intrinsic value is easy to assess, it only tells part of the story. Traders need to understand the extrinsic or time value of options as well in order to gauge how profitable the option is likely to be.
Thus, understanding intrinsic value and time value can help traders gauge the potential risks and rewards of the options trade. Investors use this deeper understanding to inform which options trading strategies they use.
When it comes to the profitability of an options trade, investors also need to take into account the premiums they pay to buy an option, along with related commissions and fees. There are also other factors that play a role in the pricing of an options contract, such as the option’s implied volatility. This is the aspect of options pricing that takes into account the market sentiment as to the future volatility of an option’s underlying security, and can have a major influence on the price of an option as well.
The Takeaway
Understanding how options are priced is a complicated business, and knowing the two main components — intrinsic value and time value — is essential. While intrinsic value is simply the tangible face value of the contract — because it’s the amount the buyer would receive if they exercised the option right now — time value is a more complex calculation.
The time value of an option, expressed as its premium, is part of an option’s extrinsic value and it includes the volatility of the underlying asset and the time to expiration. The more volatility and the more time to the option’s expiry date, the higher the premium or value of the option.
If you’re curious to learn more about options trading, you can get started with SoFi’s user-friendly platform, which offers access to a library of educational content about options. Plus, the platform’s intuitive design allows you to trade options through the mobile app or the web platform.
Photo credit: iStock/Moyo Studio
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