Intrinsic and Time Value of Options

Professional investors rely on their income from the Indian financial market to make a living. Hence, they need to find investments with the highest profit potential. They have a common strategy: Equities for value investing and Options Trading for short-term profits. This blog details a term associated with the premium of an Options contract. As Options traders leverage this premium amount to make profits, it is vital to understand the intrinsic value and time value of options and how they can help you be a professional Options trader.

What are Options Contracts?

Options, or Options contracts, are a type of agreement between two parties, whereby the buyer has the right but not the obligation to buy or sell an underlying asset. The asset must be bought or sold - depending on the type of Options contract - on a specific date and at a predetermined asset price.

There are primarily two types of Options contracts:

Call Options

This is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties. Since there is no obligation to purchase as dictated by the call Option, you do not need to execute it unless it is profitable to you.

Put Options

A Put Option works exactly opposite to the Call Option. While the call Option equips you with the right to buy, the put Option empowers you with the right to sell the stock on the date agreed upon by the contracting parties.

Some of the essential terms that are often used in Options trading are:

• Strike Price: Also known as exercise price, this is the price of the asset at which the two parties agree to buy or sell the underlying asset in an Options contract.
• Premium: This refers to the amount that the buyer pays to the seller of the asset to avail of the Options contract benefits. It is essentially the market price of the Options contract itself.
• Expiration Date: This refers to the future date by which the investor must exercise an Options contract. Beyond the expiration date, the Options contract will expire worthlessly.
• Spot Price: The current price of the underlying asset attached to the call Option contract.
• In-The-Money (ITM) call Option: When the underlying asset price is higher than the strike price.
• Out-of-the-money (OTM) call Option: When the underlying asset price is lower than the strike price.

What is Intrinsic Value in Options Contract?

The intrinsic value in an Options contract essentially means the current market value of the contract. When you talk about the intrinsic value, it refers to how much ‘in-the-money’ the contract is currently. For example, if you have a call Option contract with a strike price of Rs 200 on a stock that is currently priced at Rs 300, the intrinsic value of the call Option will be Rs 100 (300-200).

If the buyer exercises the right to buy, he will be paying Rs 200 (the strike price) and can sell the stock in the market at Rs 300, making a Rs 100 profit. Hence, the intrinsic value calculates what the buyers stand to make as profits at any time before the expiration of the contract. Notably, the intrinsic value for contracts that are ‘out-of-the-money’ is always zero as no buyer would exercise the right when it will result in loss.

What is the Time Value of Options Contract?

As the name suggests, the time value is the additional money a buyer is willing to pay over the intrinsic value for additional time until the expiration date. The idea behind time value is that if an Options contract is far from its expiration date, it has more potential to be ‘in-the-money’ or go towards the buyer’s preferred direction. For example, if one Option is three months from expiry and the other is two months away, the former will have a greater time value.

How does Time Value work in Options?

To understand how time value works in Options, you must understand that the premium amount for any contract is the total of its intrinsic value and the time value. You can calculate the time value of an Options contract as:

Time Value = Option Premium - Intrinsic Value

Taking the same example as above, let’s say the Rs 200 Option has a premium of Rs 150. The intrinsic value is Rs 100. For this, the time value will be Rs 50 (150-100).

How to calculate the Intrinsic value of Options?

The formula to calculate the Options premium is identical for every associated term. Here too, you can calculate the intrinsic value of Options using the following formula:

Intrinsic Value = Options Premium - Time Value

Once you know the time value of the contract, you can use the payable or receivable premium amount to find out how much the contract is worth at any time before expiry.

Conclusion:

The intrinsic value and time value of Options are vital in serving the value of the Options contract. Now that you understand the time value of Options along with their intrinsic value, you can make informed decisions regarding your Options trading. For more information, you can reach out to the experts at IIFL.