Intrinsic value of an
option: a detailed guide
Introduction: The concept of intrinsic value plays a central
role in understanding options trading. When trading options, whether it's a
call option or a put option, one of the fundamental components you need to
grasp is the intrinsic value of the option. It tells you how much value the
option holds if it were to be exercised at the present moment. Let's explore
what intrinsic value is, how to calculate it, and why it matters in the broader
context of options pricing.
What Is an Option?
An option is a
financial derivative that grants the holder the right, but not the obligation,
to buy or sell an underlying asset (usually stocks, commodities, or indexes) at
a pre-set price, called the strike price, on or before a certain date (the
expiration date).
Options are divided
into two types:
Call options: These give the holder the right to buy the
underlying asset at the strike price.
Put options: These give the holder the right to sell the
underlying asset at the strike price.
Intrinsic value of an
option
The intrinsic value
of an option represents the "real" or "true" value of the
option if it were exercised immediately. In simpler terms, it's the amount by
which an option is in-the-money (ITM), which means the current price of the underlying
asset is favorable for exercising the option.
For call options,
intrinsic value is the difference between the underlying asset’s current market
price and the strike price, but only if the asset’s current price is above the
strike price.
For put options,
intrinsic value is the difference between the strike price and the underlying
asset’s current market price, but only if the asset’s current price is below
the strike price.
When an option has
no intrinsic value (because it is out-of-the-money), it is purely speculative
and its price is driven by factors such as volatility, time to expiration, and
market sentiment (collectively called extrinsic value or time value).
Calculating intrinsic
value of a call option
The formula for the
intrinsic value of a call option is:
Intrinsic Value of Call Option
=
max
(
Current Market Price of Underlying Asset
−
Strike Price
,
0
)
Intrinsic Value of Call Option=max(Current Market Price of Underlying Asset−Strike Price,0)
If the current market price of the asset is greater than the
strike price, the intrinsic value is the difference between them.
If the strike price is higher than the current market price,
the intrinsic value is zero because the option is out-of-the-money.
Example for call option:
Let’s say you own a call option for a stock with a strike
price of Rs.100, and the current market price of the stock is Rs.120.
Intrinsic Value
=
Max
(
120
−
100
,
0
)
=
Max
(
20
,
0
)
=
20
Intrinsic Value=Max(120−100,0)=Max(20,0)=20
So, the intrinsic value of this call option is Rs.20. This
means that if you exercise this option, you would gain Rs.20 per share.
On the other hand,
if the current market price were Rs.90 (below the strike price of Rs.100), the
intrinsic value would be zero, because the option would not be worth
exercising.
Calculating Intrinsic Value of a Put Option
The formula for the intrinsic value of a put option is:
Intrinsic Value of Put Option
=
max
(
Strike Price
−
Current Market Price of Underlying Asset
,
0
)
Intrinsic Value of Put Option=max(Strike Price−Current Market Price of Underlying Asset,0)
If the strike price is higher than the current market price,
the intrinsic value is the difference between them.
If the current market price is higher than the strike price,
the intrinsic value is zero, as the put option is out-of-the-money.
Example for put option:
Assume you hold a put option for a stock with a strike price
of Rs.100, and the current market price of the stock is Rs.80.
Intrinsic Value
=
Max
(
100
−
80
,
0
)
=
Max
(
20
,
0
)
=
20
Intrinsic Value=Max(100−80,0)=Max(20,0)=20
So, the intrinsic
value of this put option is Rs.20, meaning you would profit Rs.20 per share if
you exercised the option. If the market price were Rs.110 (above the strike
price), the intrinsic value would be zero, as the put option would not make
sense to exercise.
In-the-Money (ITM), At-the-Money (ATM), and Out-of-the-Money
(OTM) Options
The intrinsic value of an option is directly tied to whether
it is in-the-money, at-the-money, or out-of-the-money.
In-the-Money (ITM):
A call option is in-the-money if the current market price of
the underlying asset is above the strike price.
A put option is in-the-money if the current market price of
the underlying asset is below the strike price.
In both cases, the option has a positive intrinsic value.
At-the-Money (ATM):
Both call and put
options are at-the-money when the current market price of the underlying asset
is equal to the strike price.
The intrinsic value
is zero because the option holder neither gains nor loses by exercising the
option.
Out-of-the-money (OTM):
A call option is out-of-the-money when the current market
price of the underlying asset is below the strike price.
A put option is out-of-the-money when the current market
price of the underlying asset is above the strike price.
In both cases, the intrinsic value is zero because the
option is not worth exercising.
Why intrinsic value matters
Understanding
intrinsic value is crucial for several reasons:
Accurate valuation:
The total price of an option, known as
the premium, consists of intrinsic value and extrinsic value (time value).
Knowing the intrinsic value allows traders to break down the option price and
determine how much is driven by real value and how much is speculative.
Exercising options:
When deciding whether to exercise an
option, the intrinsic value plays a pivotal role. If an option is in-the-money,
it may be worth exercising to capture the difference between the strike price
and market price. Conversely, exercising an out-of-the-money option would
result in a loss.
Trading decisions:
Traders often focus on in-the-money
options because they have tangible value. However, out-of-the-money options
with zero intrinsic value might still be worth holding or trading due to their
time value and potential for price movement before expiration.
Risk management: Understanding intrinsic value can help traders
manage risk more effectively by giving them a clear sense of how much real
value their options hold at any point in time.
Limitations of
intrinsic value
While intrinsic value
is a critical component of options pricing, it does have its limitations:
Time sensitivity:
Intrinsic value ignores the time
remaining until expiration. Options with a long time to expiration might have
significant extrinsic value, even if their intrinsic value is low or zero.
Volatility ignored:
The intrinsic value calculation does not
take into account the potential for the price of the underlying asset to change
dramatically, which is a critical factor in the pricing of options.
Conclusion
In summary, the
intrinsic value of an option represents the real, tangible value of the option
if exercised immediately. For a call option, it's the difference between the
current market price of the asset and the strike price, while for a put option,
it's the reverse. The intrinsic value is always zero or positive, as it
reflects the in-the-money portion of the option.
By calculating and
understanding the intrinsic value, traders can make more informed decisions
regarding their options positions, exercise choices, and overall strategy.
However, it’s important to combine this understanding with other elements like
extrinsic value, volatility, and time to expiration to fully grasp the complexities
of options trading.
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