WHY THE INTRINSIC VALUE OF OPTIONS CONTRACTS CAN NEVER BE NEGATIVE?

 

   The intrinsic value of an options contract is an essential component of its overall value, representing the difference between the option's strike price and the current market price of the underlying asset. Importantly, the intrinsic value can never be negative. To understand why this is the case, let’s delve into the definition of intrinsic value, how it is calculated, and why its value is bound to zero or a positive number. This exploration will also touch on other related concepts like time value, the structure of call and put options, and market dynamics that help clarify why negative intrinsic values are impossible.

 

What Is Intrinsic Value?

 

   In the simplest terms, the intrinsic value of an option reflects how much an option is “in the money” (ITM). If the option is profitable to exercise at the present moment, then it has intrinsic value. Specifically, intrinsic value depends solely on the relationship between the current market price of the underlying asset and the option’s strike price:

 

For call options, intrinsic value is calculated as:

 

Intrinsic Value

=

Current Price of Underlying Asset

−

Strike Price of Call Option

Intrinsic Value=Current Price of Underlying Asset−Strike Price of Call Option

For put options, intrinsic value is calculated as:

 

Intrinsic Value

=

Strike Price of Put Option

−

Current Price of Underlying Asset

Intrinsic Value=Strike Price of Put Option−Current Price of Underlying Asset

   If the calculation results in a positive number, the option has intrinsic value. If the calculation results in a negative number, the intrinsic value is zero. This makes sense because the holder of the option wouldn’t exercise it if it led to a loss—so the intrinsic value is capped at zero.

 

Call options and intrinsic value

 

A call option gives the holder the right (but not the obligation) to buy an underlying asset at a predetermined strike price before or at the option’s expiration. To grasp why its intrinsic value cannot be negative, consider the following situations:

 

In-the-money (ITM):  If the market price of the underlying asset is higher than the strike price, the intrinsic value is the difference between the two. For example, if you own a call option with a strike price of Rs.50 and the asset is currently trading at Rs.60, the intrinsic value is Rs.10. Exercising the option would allow you to purchase the asset at Rs.50 and immediately sell it in the open market for Rs.60, generating a Rs.10 profit per unit.

 

At-the-money (ATM) or Out-of-the-money (OTM):  If the market price is equal to or less than the strike price, the option is either at-the-money or out-of-the-money. Here, it wouldn’t make sense to exercise the option, as buying the asset at the strike price wouldn’t result in a profit. In this case, the intrinsic value of the option is zero, not negative. No rational trader would exercise an option to buy an asset at a higher price than the current market value, so the intrinsic value remains zero.

 

   Thus, call options can only have intrinsic values that are positive or zero because their worth is always derived from how much they can be exercised for profit.

 

Put options and intrinsic value

 

   A put option gives the holder the right (but not the obligation) to sell the underlying asset at a predetermined strike price. Just as with call options, the intrinsic value of a put option can only be positive or zero.

 

In-the-money (ITM):  If the market price of the underlying asset is lower than the strike price, the put option is in the money. The intrinsic value is the difference between the strike price and the current market price. For example, if you hold a put option with a strike price of Rs.50 and the asset is trading at Rs.40, the intrinsic value is Rs.10. You could exercise the option to sell the asset at Rs.50 while the market is willing to buy it for only Rs.40, locking in a Rs.10 gain.

 

At-the-money (ATM) or Out-of-the-money (OTM):  If the market price is equal to or greater than the strike price, the option is either at-the-money or out-of-the-money, respectively. In these cases, exercising the option would result in a loss or no gain, so the intrinsic value of the option is zero.

 

   Put options, like call options, do not have negative intrinsic values because exercising them in situations where the current market price is higher than the strike price would be irrational. The worst-case scenario for intrinsic value is zero, indicating that the option is not worth exercising at the moment.

 

Why intrinsic value can never be negative

 

   The fundamental reason that the intrinsic value of an option can never be negative is rooted in the concept of optional exercise. Both call and put options provide the right but not the obligation to buy or sell the underlying asset. This key feature protects the holder from being forced to make unprofitable trades. No one would willingly exercise an option to incur a loss. Therefore, in cases where exercising the option would result in a loss, the option holder simply refrains from exercising it, and its intrinsic value is set to zero.

 

   Another perspective is that intrinsic value measures potential profit, not loss. Negative intrinsic value would imply that the option holder could lose money by exercising, but because they are not required to exercise, such a situation would never materialize.

 

Time value and total option premium

 

It’s also important to differentiate between intrinsic value and time value when discussing options. The total premium (price) of an option consists of both intrinsic value and time value:

 

Option Premium

=

Intrinsic Value

+

Time Value

Option Premium=Intrinsic Value+Time Value

 

   Even when the intrinsic value is zero (when the option is at-the-money or out-of-the-money), the option might still have a positive premium due to time value. The time value represents the possibility that the option might move into the money before it expires. Time value diminishes as the option’s expiration date approaches, a phenomenon known as time decay.

 

   However, time value does not affect intrinsic value directly. Even if time value is positive, the intrinsic value of the option remains determined solely by the immediate relationship between the strike price and the underlying asset’s current market price.

 

Practical example: intrinsic value calculation

 

   Consider a stock trading at Rs.100. You own a call option with a strike price of Rs.90 and a put option with a strike price of Rs.110.

 

Call Option:

 

Market price = Rs.100

Strike price = Rs.90

Intrinsic value = Rs.100 – Rs.90 = Rs.10

Since the option is in the money, the intrinsic value is positive.

 

Put option:

 

Market price =  Rs.100

Strike price =  Rs.110

Intrinsic value =  Rs.110 – Rs.100 = Rs.10

The put option is also in the money with positive intrinsic value.

Now, if the stock price moves to Rs.95:

 

The call option’s intrinsic value drops to Rs.5 (Rs.95 – Rs.90).

The put option’s intrinsic value drops to Rs.5 (Rs.110 – Rs.95).

If the stock price rises above Rs.110 or falls below Rs.90, one of these options becomes out-of-the-money, and its intrinsic value will be zero, but never negative.

 

Conclusion

 

   The intrinsic value of options contracts can never be negative because of the nature of options as rights rather than obligations. An option holder can always choose not to exercise the option if it’s out-of-the-money, which means that intrinsic value bottoms out at zero. Whether it’s a call or a put option, intrinsic value only measures potential profit, not loss. This concept underscores the flexibility and risk-limiting nature of options trading and makes options a versatile tool in various investment strategies. Understanding intrinsic value is fundamental to navigating the options market effectively.