How to Find the Intrinsic Value of an Option
Learn to calculate an option's intrinsic value, revealing its immediate worth and how it contributes to the overall option premium.
Options are versatile financial instruments that provide the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price by a certain date. This flexibility allows investors to manage positions for speculation or to hedge against market fluctuations. When trading options, a price is paid by the buyer to the seller, known as the option premium. This premium represents the current market value of the option contract and is composed of different elements, including intrinsic value.
Understanding Intrinsic Value
Intrinsic value represents the immediate profit an option holder would realize if the option were exercised at the current moment. This value is directly tied to the relationship between the underlying asset’s current market price and the option’s strike price. An option has positive intrinsic value only when it is “in-the-money” (ITM). If an option is not in-the-money, its intrinsic value is zero.
An option is considered “in-the-money” when its exercise would result in a financial gain. For call options, this occurs if the underlying asset’s price is higher than the option’s strike price. Conversely, a put option is in-the-money if the underlying asset’s price is lower than the option’s strike price. An option is “at-the-money” (ATM) if the underlying asset’s price is equal to the strike price, resulting in zero intrinsic value. Options are “out-of-the-money” (OTM) if exercising them would lead to a loss, meaning they also have zero intrinsic value.
Calculating Intrinsic Value for Call Options
To determine the intrinsic value of a call option, the formula involves comparing the underlying asset’s current market price to the option’s strike price. The calculation is: Intrinsic Value = Underlying Stock Price – Strike Price.
For example, if a call option has a strike price of $50 and the underlying stock is currently trading at $55, the intrinsic value is $55 – $50 = $5.00. This indicates the immediate profit per share if the option were exercised. However, if the same call option had a strike price of $55 and the stock was trading at $50, the calculation would yield -$5, but the intrinsic value would be $0.00, as it is an out-of-the-money option.
Calculating Intrinsic Value for Put Options
The calculation for the intrinsic value of a put option differs from that of a call option. For a put option, the formula is: Intrinsic Value = Strike Price – Underlying Stock Price.
Consider a put option with a strike price of $40, and the underlying stock is trading at $35. The intrinsic value would be $40 – $35 = $5.00. This amount represents the immediate profit per share from exercising the put option. Conversely, if the put option had a strike price of $35 and the stock was trading at $40, the result would be -$5, making the intrinsic value $0.00 since it is an out-of-the-money option.
Intrinsic Value and Option Pricing
Intrinsic value is a fundamental component of an option’s overall price, known as the option premium. The option premium comprises intrinsic and extrinsic value, expressed as: Option Premium = Intrinsic Value + Extrinsic Value.
Extrinsic value, also referred to as time value, accounts for the portion of the option’s premium that exceeds its intrinsic value. It reflects factors such as the time remaining until the option’s expiration date and the implied volatility of the underlying asset. As an option approaches its expiration, its extrinsic value typically diminishes, leaving intrinsic value as the primary determinant of the option’s price if it is in-the-money.