The price of an option, also known as the premium, is made up of two factors:
Intrinsic Value (moneyness)
The intrinsic value of an option contract is the part of the option price that is In-the-Money (ITM).
Extrinsic Value (time value)
The extrinsic value of an option contract is the part of the option price that is Out-of-the-Money (OTM).
The intrinsic value is the real value of the option contract. It can be thought of as the value of the contract if expiration was today.
Extrinsic value is a combination of the time until expiration and the possibility that the contract will finish In-the-Money. As expiration approaches and/or the possibility becomes less likely, the extrinsic value decreases. We will discuss this topic in more detail later.
There are three terms that need need to be explained further. They are:
In-the-Money (ITM)
The intrinsic value of an option contract is different for call and put options. A call option is ITM if the underlying stock price is greater than the strike price. A put option is ITM if the underlying stock price is less than the strike price. An ITM option has both intrinsic value and extrinsic value.
Out-of-the-Money (OTM)
The time value of an option contract is also different for call and put options. A call option is OTM if the underlying stock price is less than the strike price. A put option is OTM if the underlying stock price is greater than the strike price. An OTM option has no intrinsic value and only extrinsic value.
There is also At-the-Money Options, which are:
At-the-Money (ATM)
A call or put option is ATM if the underlying stock price is the same as the strike price. An ATM option has no intrinsic value and only extrinsic value.
There are some simple formulas to calculate intrinsic value and time value:
Call Option Intrinsic Value = Underlying Stock Price - Strike Price
Call Option Time Value = Call Premium - Call Intrinsic Value
Put Option Intrinsic Value = Strike Price -Underlying Stock Price
Put Option Time Value = Put Premium - Put Intrinsic Value
Exxon Mobil is currently trading at $74.65 per share
with 1 day until the November contracts expire. The November 70 call
premium is $5.05 and the November 70 put premium is $0.46.
Call Option Intrinsic Value: $74.65 - 70 = $4.65
intrinsic value
Call Option Time Value: $5.05 - $4.65 = $0.40 time
value
Put Option Intrinsic Value: 70 - $74.65 = $0.00 (there
is no intrinsic value because it is out-of-the-money.)
Put Option Time Value: $0.46 - $0 = $0.46 time value
Apache Corp. is currently trading at $97.07 per share
with 29 days until the December contracts expire. The December 100 put
premium is $5.20 and the December 100 call premium is $2.40.
Call Option Intrinsic Value: $97.07 - 100 = $0.00
(there is no intrinsic value because it is out-of-the-money.)
Call Option Time Value: $2.40 - $0 = $2.40 time value
Put Option Intrinsic Value: 100 - $97.07 = $2.93
intrinsic value
Put Option Time Value: $5.20 -$2.93 = $2.27 time value
The put option in Example one and the call option in Example two have no intrinsic value- only time value.
In Example one there is 1 day until expiration. In Example two there are 29 days until expiration. Option contracts with more time until expiration typically have more time value.
Understanding how to calculate intrinsic value and time value will help an investor understand option pricing models. This lesson also presents a new concept: the less time until expiration an option contract has, the less time value it will have. Keep this in mind as we will touch on this subject in future lessons.
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