As you begin your study and understanding of the options instruments, one term is going to come up over and over, intrinsic value. So what is intrinsic value? How is it calculated? How is it different from an options market value?
Intrinsic value is the real or tangible value of an options price. According to Investopedia “Intrinsic value is the value that any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option’s price that is not lost due to the passage of time.”
To understand what the intrinsic value of an option is one must first understand what an option represents. Call options provide the buyer the right to buy the underlying security at a specific price within a specific amount of time. When the call option affords its owner the right to buy the security at a price that is less than the current market price, that option is said to be “in-the- money” (ITM). In the money options contain intrinsic value. Put options provide the buyer the right to sell the underlying security at a specific price within a specific amount of time. When the put option affords its owner the right to sell the security at a price that is greater than the current market price, that option is said to be “in-the-money” (ITM). All options, whether calls or puts, that are in-the-money contain intrinsic value. Traders and investors often refer to the intrinsic value of an option as the” real value” of the option.
Calculating intrinsic value is very straightforward. Since a call option allows the owner to buy the underlying security at the strike price of the option, then the formula to calculate intrinsic value becomes the current market price minus the strike price of the call option. If the result is a value that is greater than zero, the option has intrinsic value. This would be the case when the current market price of the security is greater than the strike price of the call option in question. To calculate the intrinsic value of a put option, the formula would simply be reversed. The formula to calculate the intrinsic value of a put option would be the strike price of the put minus the current market price of the security. If the value is greater than zero, the option has intrinsic value. This would be the case when the current market price of the security is less than the strike price of the put option in question.
Lastly, how is intrinsic value different from an options market value? An options market value or price is the current price that an option may be bought or sold in the marketplace. Options are forward-looking financial instruments. They are speculative estimates of what is going to happen to a securities price during a specific time in the future. Because of the uncertainty about the future price movement of the security, the options market will attempt to predict how far from the current value the security might trend. Typically, in a highly liquid marketplace, buyers and sellers negotiate based upon their own expectations until a consensual price can be reached. That price is the market value of the option. If the option is in the money than it will contain intrinsic value. In almost all cases the total value of the option will be greater than the intrinsic value part of an options price. The value that is above and beyond the intrinsic value (when an option does in fact have intrinsic value), is called “extrinsic value”. The extrinsic value of an option is quite simple to calculate. First, you must determine if the option has any intrinsic value. If it does, then the extrinsic value of the option is simply the difference between the current options price and the intrinsic value. If there is no intrinsic value, which is the case for all options that are not in the money, then all the options price is referred to as extrinsic value.
Call Options: Current market price of security – strike price of call option = intrinsic value
Market price of option – intrinsic value = extrinsic value
Put Options: Strike price of put option – current market price of security = intrinsic value
Market price of option – intrinsic value = extrinsic value
Jeff McAllister
OptionsANIMAL Instructor
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