Time and Intrinsic Value of Stock Options (includes calculator)
Stock options are contracts between two parties that provide the purchaser of the contract with the right, but not the obligation to buy (“call options”) or sell (“put options”) the underlying asset at a specified price before the agreed-upon expiration of the contract. The seller of the contract accepts the obligation to fulfill the contract to the purchaser. Stock options offer investors the opportunity to speculate on market movement with limited risk; namely, the price of the contract. Before engaging in options trading, investors should develop an understanding of the two components that drive option value: intrinsic value and time value.
Revisiting the Types of Stock Options
Before looking at the valuation components, it may help to review the basic types of stock options and how they are commonly used:
Call Options: A trader who believes that the price of a particular stock will increase could purchase a call option and gain the right to purchase the stock at a specified price within a set time period. This is referred to as a long call. A trader who believes the stock price will decline might choose to “short” the stock or write a call option, a strategy known as a short call.
Put Options: If a trader believes that the price of a specific stock will decrease, they may buy the right to sell the stock at a set price. This is known as a long put. If, at expiration, the stock is priced above the exercise price, the trader would simply choose to let the contract expire and only lose the premium they paid for the contract. If a trader believes that a stock will increase in price, they may simply buy the stock or choose to sell a put, a strategy known as a short put.
The Two Components of Option Valuation
Intrinsic Value: The intrinsic value refers to the portion of the option premium that is “in the money”. The intrinsic value for an option that is in-the-money is calculated as the difference between the current stock price of the underlying security and the strike price.
For call options: If the stock currently trading above the strike price, the intrinsic value is calculated as the difference between stock price and the strike price of the option.
For put options: If the stock price is lower than the strike price, the intrinsic value is calculated as the difference between the strike price and current stock price.
Time Value: Also referred to as “extrinsic value”, the time value is represented as the amount in which the option price exceeds its intrinsic value. The extrinsic value of an option diminishes over time as it is directly related to how much time the option has until expiration. In other words, the more time the option has until expiration, the better its chances of ending up in-the-money. On the expiration day, the only value an option has is in its intrinsic value, so the option is worthless if it isn’t in-the-money.
________________________________________________________________
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
Recent Posts
- How to Calculate a Stock Market Profit
- Three Basic Financial Concepts for Investors
- Understand an Calculate the Capital Asset Pricing Model (CAPM)
- Calculate Your Retirement Savings Requirements
- The Basics of Stock Market Futures Trading
- How to Calculate Internal Rate of Return (IRR)
- How to Calculate Earnings per Share
- What the Par Value of a Stock Means
- Bond Value Calculator
- Some Basic Forex Trading Tips
Leave a Comment
You must be logged in to post a comment.