Intrinsic Value and Time Value of Options

To gain a comprehensive understanding of options and optimise their potential in the derivative market, it is crucial to grasp two key concepts, the intrinsic value and time value of options. Intrinsic value represents the tangible worth of an option based on the current market price of the underlying asset. It reflects the immediate profit an option holder could gain by exercising the option at its current state. On the other hand, time value represents the additional value ascribed to an option beyond its intrinsic value. It accounts for the potential future price movements of the underlying asset before the option's expiration.

Intrinsic value serves as a foundation for options pricing and determines whether an option is "in the money," "at the money," or "out of the money." For call options, the intrinsic value is positive when the market price of the underlying asset exceeds the option's strike price. Conversely, for put options, the intrinsic value is positive when the market price is below the strike price. Understanding intrinsic value is crucial as it establishes a lower limit for an option's price, preventing it from trading below its intrinsic value due to arbitrage opportunities.

What is the Intrinsic Value of Options?

This is the simplest part of the premium calculating process. Whether or not a trader wants to acquire an option is logically dependent on how much profit they hope to gain from the contract. The difference between the strike price and the spot price (i.e. the price of the asset in real-time on the market) is now the profit that option purchasers will make if they hold the option until maturity.  

There are variations between the price and the current price of the asset on some days, even before the expiry date. This distinction helps traders forecast the option's profitability on the expiry date. The intrinsic value of an option is the notional profit generated by the difference between the strike price and the spot price.

The intrinsic value of the call option = Spot Price - Strike Price 

The Intrinsic value of the put option = Strike Price - Spot Price 

Assume option buyer Mr. B purchases a call option on stock X at Rs. 2000 strike price from seller Mr. S. The option's expiration date is one month from today. However, two weeks in, the asset's spot price is now Rs. 2020. As a result, the intrinsic value of the option is Rs. 20. However, if the asset's market price had fallen to less than Rs. 2000, say Rs. 1080, the intrinsic value of the option would not have been Rs. (-20). It would have been Rs. 0 instead. As a result, intrinsic value exactly reflects the degree of profit and is never negative. 

As a result, the intrinsic value of an option is the fraction of the option premium that is impacted by changes in the absolute value of the possible profit from the option. This is due to the profit, which is the difference between the strike price and the spot price, being a part of the specifications of the option contract itself.

What is the Time Value of Options? 

The time value, as the name implies, is the extra money a buyer is ready to pay beyond the intrinsic worth for extra time till the expiration date. The notion behind time value is that if an Options contract is close to expiration, it has a better chance of being 'in-the-money' or moving in the buyer's chosen direction. For example, if one Option expires in three months and the other in two months, the former will have a higher time value.

Importance of Intrinsic Value

Intrinsic value is a crucial concept in options trading as it provides a foundation for understanding the worth and potential profitability of an option. Understanding the importance of intrinsic value is essential for options traders, as it serves several key purposes.

Determining Profitability

Intrinsic value indicates the immediate profit that can be gained by exercising an option. It allows traders to assess whether an option is "in the money" (ITM) and if it is worth exercising. By comparing the intrinsic value to the cost of the option, traders can evaluate the potential profitability of their positions.

Setting a Price Floor

Intrinsic value acts as a lower limit for the price of an option. It ensures that the option cannot be traded below its intrinsic value, as this would create an arbitrage opportunity. Traders can use the intrinsic value as a guidepost when buying or selling options, helping them avoid overpaying or undervaluing the contracts.

Risk Management

Intrinsic value provides valuable insights into the risk associated with an option position. For example, an option with a high intrinsic value means that a substantial portion of its price is based on the underlying asset's current price. This suggests that the option is less sensitive to changes in the underlying asset's price, potentially reducing the overall risk of the position.

Option Expiration

Intrinsic value plays a crucial role in determining the decision to exercise or let an option expire. If an option has positive intrinsic value, it may be advantageous to exercise it before expiration to capture the immediate profit. Conversely, if an option has no intrinsic value or is "out of the money" (OTM), it may be more prudent to let it expire worthless, saving the cost of exercising.

How to Calculate the Intrinsic Value

The formula for calculating the Options premium is the same for all linked terms. You may also use the following formula to compute the intrinsic value of Options:

Intrinsic Value = Options Premium - Time Value

Once you know the contract's time value, you can use the payable or receivable premium amount to determine how much the contract is worth at any moment before it expires.

Factors Affecting Intrinsic Value and Time Value of Option

Some of the factors affecting the intrinsic value & time value of an option are:

Time to Expiration

Time to expiration is one of the key factors that affect the time value of an option or any other financial instrument. Time value refers to the additional value that an option possesses beyond its intrinsic value, which is the value it would have if it were exercised immediately.

Volatility

Higher volatility increases the likelihood of significant price swings in the underlying asset. Consequently, options on highly volatile assets tend to have higher time value due to the increased probability of profiting from price fluctuations.

Dividends

Dividends can impact the time value of options, particularly for stocks. When a dividend is expected during the option's lifespan, the value of call options may decrease, while put options may increase in value. This is because dividends reduce the value of the underlying stock, affecting the options price.

Interest Rates

Interest rates can also influence the time value of options. Higher interest rates can increase the time value of call options, as investors may prefer options over buying the underlying asset outright.

Extrinsic and Intrinsic Values Roles in Risk Management

Implied Volatility (IV) reflects the expected stock price volatility throughout an option's lifespan. Higher IV suggests a greater likelihood of the stock price experiencing significant changes by the contract's expiry.

Understanding different analytical approaches aids in making informed decisions in options trading:

Implied Volatility

The implied volatility, or IV, measures the predicted volatility of the stock price during the option contract's life. If IV is high, the stock price is likely to rise moreover the period till the expiry date.

Technical Analysis

In the near term, it is better to depend on technical analysis (simply analysing price and volume patterns) to determine which direction the asset's price is heading. It will aid in projecting the option's intrinsic value by predicting the spot price (the strike price is already known under the contract). Technical analysis techniques include trend indicators (such as Supertrend and MACD), momentum indicators (such as RSI), volatility indicators, and volume indicators.

News Analysis

Stock prices change not only due to actual events in the market but also the perception of those same events among both institutional and retail investors. Therefore, keep track of the news to check if any positive or negative news is coming up. 

One can use the above metrics to not only decide on whether to trade an option but also to choose between two or more options.

Conclusion 
Intrinsic value and time value are key factors in determining the pricing and profitability of options in financial markets. Intrinsic value represents the immediate profit gained by exercising an option based on the strike price and underlying asset price. Time value represents the premium traders are willing to pay for potential future price movements before the option's expiration. Understanding these concepts is essential for making informed decisions in options trading. You can download the BlinkX trading app, and explore tons of investment opportunities in the share market.