Section 5.2 β€” Intrinsic Value & Time Value

  • πŸ’‘ What Is Intrinsic Value?

    • ntrinsic Value (IV) = The amount an option is β€œin the money.”

    • It represents real, immediate profit if the option were exercised now.

    • It is never negative (minimum is 0).

    • The option’s premium (price) always includes intrinsic value.

  • πŸ“ Formula for Intrinsic Value:

    • Call Option:
      Stock Price – Strike Price = Intrinsic Value

    • Put Option:
      Strike Price – Stock Price = Intrinsic Value

1. πŸ“ˆ For Call Options:

  • In the Money (ITM): Stock price > Strike price

  • At the Money (ATM): Stock price = Strike price

  • Out of the Money (OTM): Stock price < Strike price

  • Example:

    • XYZ 50 Call, stock trading at $57 β†’ $7 In the Money
      β†’ Intrinsic Value = $7

    • ABC 50 Call, stock trading at $47 β†’ Out of the Money (no intrinsic value)

2. πŸ“‰ For Put Options:

  • In the Money (ITM): Stock price < Strike price

  • At the Money (ATM): Stock price = Strike price

  • Out of the Money (OTM): Stock price > Strike price

  • Example:

    • XYZ 50 Put, stock trading at $43 β†’ $7 In the Money
      β†’ Intrinsic Value = $7

    • ABC 50 Put, stock trading at $53 β†’ Out of the Money (no intrinsic value)

βš–οΈ Summary: Intrinsic Value Rules

Option Type / In the Money.. / At the Money.. /Out of the Money.. / Formula

  • Call / Stock price > Strike price / Equal / Stock price < Strike price / Stock βˆ’ Strike = IV

  • Put / Stock price < Strike price / Equal / Stock price > Strike price / Strike βˆ’ Stock = IV

🧠 Buyer vs. Seller Benefit:

  • Buyer: Wants the option to have intrinsic value (in the money).

  • Seller: Prefers option to have no intrinsic value (out of the money) so it expires worthless.

Options

〰️

Options 〰️

⏳ Time Value:

  • Time Value (TV) = Portion of the premium based on time remaining and market demand.

  • Subjective β€” depends on volatility, expiration time, and investor sentiment.

  • Premium = Intrinsic Value + Time Value

πŸ“ Formula:

Intrinsic Value + Time Value = Premium

πŸ“‰ Put Contracts:

  • Buyer of a Put:

    • Right: To sell the stock at the strike price.

    • Goal: Wants the stock price to fall.

    • Market View: Bearish.

  • Seller (Writer) of a Put:

    • Obligation: To buy the stock at the strike price if exercised.

    • Goal: Wants stock to stay the same or rise.

    • Market View: Bullish.

  • Examples:

    1. ABC 50 Call trading at $3 premium, stock = $52

      • IV = $2 (52 – 50)

      • $2 + TV = $3 β†’ TV = $1

    2. ABC 50 Put trading at $1 premium, stock = $52

      • IV = 0 (out of the money)

      • 0 + TV = $1 β†’ TV = $1

🧩 Key Takeaways

  • Intrinsic Value: Real profit if exercised now.

  • Time Value: Extra amount investors pay for potential profit before expiration.

  • Premium: The total price = IV + TV.

  • Options lose time value as expiration approaches (called time decay).

Next Section

✺ Review questions ✺

  • The amount an option is in the money; the real value if exercised now.

  • No, it’s never negative (minimum is zero).

  • When the stock price is above the strike price.

  • When the stock price is below the strike price.

  • $7 (57 βˆ’ 50).

  • $7 (50 βˆ’ 43).

  • $1.

  • The seller (writer).