Time Value vs. Intrinsic Value

What is an Option Worth?

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Time Value. pixabay.com

One important concept  concerning options revolves around their value. Equations allow a trader to calculate a reasonable estimate for the "true" value of any option, but that model breaks down under certain conditions. For example, when news is about to be released, option buyers hope for a large change in the stock price. The possibility of a large profit encourages them to pay more for the options than they would if there were no news pending.

This is another way of saying that market players know that it is quite possible that the price of this stock will be volatile once the news is announced. And the anticipated high volatility plays a large role in the price of all options.

Similarly, option sellers demand compensation for accepting the risk that they may have to pay $2,000 (or more) to cover an option that they sold for $100, with the hope that it would expire worthless.Thus, they demand a higher premium when selling options into a news event.

Some traders prefer to ignore all theoretical considerations (i.e., they do not use equations to price options) and say the the fair price for any option is the current market price. It is very difficult to argue with that idea. After all, the current market price is the price that buyers and sellers agree (at a specific point in time) is a fair value. If they are willing to pay a given price when buying, (or accept that price as sellers), how can anyone say that the buyer or seller is not making the transaction at a fair price?


Definitions

Whatever method you choose you determine the fair price for any option, that price (premium), is the sum of the option's intrinsic value and its time value.

  • Intrinsic value is the amount by which the option is in-the money. For a call option, the intrinsic value is calculated by subtracting the strike price from the stock price. For example, a BA Nov 20 '15 130 call has an intrinsic value of $4.00 when the stock price is $134.

    For a put option, the intrinsic value is calculated by subtracting the stock price from the strike price. For example, an IBM Feb 19 '16 155 put has an intrinsic value of $7.00 when the stock price is $148.

    Only in-the-money options have an intrinsic value. At-the-money options and out-of-the-money options have an intrinsic value of zero.
     
  • Time value is the value of the option -- over and above the intrinsic value. When options are priced in the marketplace, it is the time value of the option that  makes option trading so interesting.  The intrinsic value is always known for a given stock price because the option strike price never changes (it is part of the option contract). However, several factors affect the time value. The most important factors are the time remaining in the lifetime of the option and the estimated volatility for the underlying stock -- using the time period from the current time until options expiration.

    As the lifetime of an option increases, the time value increases. That is reasonable because when there are more trading days remaining before the option expires, there is a greater chance that the option will gain value -- and that means people are willing to pay more for the option. It is true that there is also more time for the stock to move in the wrong direction, decreasing the option's value. However, when pricing options, it is the possibility of making money that determines how much investors are willing to pay.

    As the volatility of the underlying stock increases, the value of an option increases. Thus, the implied volatility (current estimate of how volatile the stock will be between the pressent time and expiration) plays a large role in the time value of the option. More volatile stocks can undergo larger price changes and their options command a higher premium than options of low-volatility stocks.

    Anything else that affects the value of an option (interest rates, dividend, stock price -- all play a role in determining the time value (or time premium).

     

    Because the intrinsic value is easily calculated, it is the time value of the option that drives the option premium higher and lower. The two most important factors are time remaining and volatility.