How to Calculate an Option’s Intrinsic Value
Learn to calculate an option's intrinsic value, a core component of its worth. Gain insight into evaluating call and put options.
Options are financial contracts giving the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. They are used to manage risk or speculate on asset price movements. Intrinsic value is the immediate profit an option holder would realize if they exercised the option now. Understanding this value helps evaluate an option’s current worth and potential profitability.
Key Option Terminology
Understanding intrinsic value requires familiarity with key options terms. The “underlying asset” is the specific security, commodity, or index on which the option contract is based. Its price movements directly influence the option’s value.
The “strike price,” also known as the exercise price, is the fixed price at which the underlying asset can be bought or sold if the option is exercised. It is fixed when the contract is created and remains constant until expiration. The “market price” of the underlying asset is its real-time trading price.
A “call option” grants the holder the right to buy the underlying asset at the strike price. A “put option” provides the holder with the right to sell the underlying asset at the strike price.
Calculating Intrinsic Value for Call Options
A call option has intrinsic value when the market price of its underlying asset is higher than the option’s strike price. This difference represents the immediate profit if the option were exercised. If the market price is equal to or lower than the strike price, the call option has no intrinsic value, meaning it is “out-of-the-money.”
The formula for calculating the intrinsic value of a call option is: Intrinsic Value = Market Price of Underlying Asset – Strike Price. For example, if a call option has a strike price of $50 and the underlying stock is trading at $55, its intrinsic value is $55 – $50 = $5. If the same call option has a strike price of $50 and the stock is trading at $48, its intrinsic value is $0, as intrinsic value cannot be negative.
Calculating Intrinsic Value for Put Options
A put option has intrinsic value when the market price of its underlying asset is lower than the option’s strike price. This allows the holder to sell the asset at a price higher than its current market value, securing an immediate profit. If the market price is equal to or higher than the strike price, the put option has no intrinsic value, making it “out-of-the-money.”
The formula for calculating the intrinsic value of a put option is: Intrinsic Value = Strike Price – Market Price of Underlying Asset. For instance, if a put option has a strike price of $50 and the underlying stock is trading at $45, its intrinsic value is $50 – $45 = $5. If the same put option has a strike price of $50 and the stock is trading at $52, its intrinsic value is $0, as intrinsic value cannot be less than zero.
Intrinsic Value Versus Time Value
An option’s total price, often referred to as its premium, is composed of two components: intrinsic value and time value. The “time value” is the portion of the option’s premium that exceeds its intrinsic value. This additional value reflects the potential for the option to become more profitable before its expiration date.
Time value is influenced by factors such as the amount of time remaining until expiration and the expected volatility of the underlying asset. Options with more time until expiration have higher time value, as there is a greater chance for the underlying asset’s price to move favorably. As an option approaches its expiration, its time value erodes, a phenomenon known as time decay. This relationship can be expressed as: Option Premium = Intrinsic Value + Time Value.