Options Intrinsic and Time Values

Description: Options Trading, Intrinsic Value, Time Value, options contract, QQQQ, options value, premium, expiration, strike, QQQQ stock, call options, in the money, out of the money

The whole purpose of options is to deliver a right to sell or buy an underlying stock at specific price. If you are buying QQQQ $40 call options and at the expiration QQQQ stock is traded at $45 then you realize $5 profit at expiration. For this right to buy or sell at specific price an options buyer has to pay premium to the options seller.

The options premium could be divided into two parts: intrinsic options value and options time value. The intrinsic value is a difference between the current underlying stock price and the strike price of the option contract. The other part of the options premium is an options time value - the price for the risk that is paid to the options seller.  let's take a look at several examples to better understand the option intrinsic value:

Example #1: You are buying in the money QQQQ 40$ call options at $2,40 per contract and QQQQ stock is traded at $39 at that moment. The QQQQ call options will expire in 2 months

The difference between strike price and the QQQQ stock price is $1 and this is intrinsic part of the options $2,40 premium you paid. The rest ($1.40) is a time value of the call options you are buying.

Example #2: You are buying in the money QQQQ 40$ call options at $1.40 per contract and QQQQ stock is traded at $39 at that moment. The QQQQ call options will expire in 1 months

The example #2 is similar to the example #1 with a difference that now the options contracts are 1 month closer to the expiration. The same as in the first example, the difference between strike price and the QQQQ stock price is $1 and this is intrinsic part of the options premium you paid. The rest ($0.40) is a time value of the call options you are buying. The closer to the expiration the lower options time value becomes.

Example #3: You are buying out the money QQQQ 40$ call options at $1.40 per contract and QQQQ stock is traded at $41 at that moment. The QQQQ call options will expire in 2 months

The difference between strike price and the QQQQ stock price is minus $1. Because you are buying out of the money options the intrinsic value of this options is equal to zero. The whole premium (!1.40) you paid for the options contract is a price for the risk and is options time value.

Example #4: You are buying out the money QQQQ 40$ call options at $0.40 per contract and QQQQ stock is traded at $35 at that moment. The QQQQ call options will expire in 2 months

The same as in example #3, because you are buying out of the money options the intrinsic value is 0. Yet, because the options contracts are deeper out the money, the options seller risk is smaller and as a result the time value is lower - only $0.40 per options contract.

Below you may see summary table of the examples above

Summary point to remember:

• Intrinsic value reflect difference between strike price and current underlying stock price;
• Time value is a price for the options seller's risk;
• In the money option's premium is a sum of the options intrinsic and option time values;
• Out of the money option's premium has only time value;
• At the expiration in the money option's premium has only intrinsic value;
• At the expiration out the money option's premium is 0;
• The closer to expiration - the fewer seller's risk is, and the lower time value is;
• The deeper out of the money options are - the fewer seller's risk is, and the lower time value is.

 

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