Option Investor
Educational Article

Time Value vs. Intrinsic Value

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In the world of options Intrinsic value and time value are parts that make up every option contract that you will buy or sell. To get a better understanding of them both, one needs to have a firm definition as to what they each mean.

Intrinsic Value is the part of the option premium that has actual value if you were to sell the option at its current price; it is easily defined as the amount the strike price of the option is in the money. It is the portion of the option that has real value and is not effected by an erosion of time. Time Value, on the other hand, is at the money options and out of the money options that have NO intrinsic value at all. The reason is because their premium is made up from nothing more than the length of time that you are paying to hold unto the option. The further out in time you purchase an out of the money or an at the money option, the greater the premium you must pay. The reason is simply that you are paying for more time. The reason an option trader should have a pretty good idea how to calculate Intrinsic Value and Time Value is important from the stand point as tit will ultimately help decide which option strike price a trader selects. It you have ever purchased an option, you will notice that if a stock were trading at 35 with about 2 weeks to go and the option at the 35 strike price were trading at 1, you know that that option is entirely made up of Time Value, because if the stock were to close at 35, 2 weeks later at expiration day, you would find the option value to be zero, as it would have expired worthless. Why? Because at expiration an option for a $35 stock with a 35 strike price has no Intrinsic Value, because what is the value of an option to exercise a stock at $35 if the stock is trading at $35. NONE! So in the above situation you can see how that $1 option was only made up of time value and had no real intrinsic value at all.


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Let's look at the table below and try calculating a few options in relationship to their Time Value and Intrinsic value

Figure 1: Time Value vs. Intrinsic Value.


Now before we figure out each of the option problems above, lets take a look at a couple of formulas that we should remember that will make it very easy to determine Time Value from Intrinsic Value.

FORMULAS:

Call Options: Intrinsic Value = the stock's current price - Call Strike Price
Time Value = Call Premium - Intrinsic Value

Put Options: Intrinsic Value = Put Strike Price - Stock's current Price
Time Value = Put Premium - Intrinsic value


Now let's look at problem #1, if the current price of XYZ is 43, use the table above to calculate the Time Value and the Intrinsic Value of the Jun 45 Call option trading at 2.50.

After you have figured out the answers for #1, do #2 through 5. (Answers below- doesn't look until you have tried them all.)

Notice in #1 that the XYZ Jun 45 Call has NO intrinsic value. Remember that intrinsic value is only associated with options that are IN-THE-MONEY. The XYZ June 45 option is OUT-OF-THE-MONEY, hence has to be entirely made up of Time Value only.
Hence, the answer to #1 has to be 2.50 of Time Value and Nothing of Intrinsic Value.

So how well did you do with the rest?

HINT: If the option is out or at the money the entire option premium is made up of TIME VALUE ONLY.

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