Lesson 4 Intrinsic Value and Time Value of Options
Any item, commodity and asset has its value, and of course options are no exception. We will introduce how options are priced in detail in the following chapters, mainly introducing two methods: the binomial option pricing model and the Black-Scholes model pricing model. In this chapter, we first introduce the intrinsic value and time value of options.
When we are trading options, the option price we see in the brokerage actually includes two parts of value: one part is the intrinsic value; the other part is the time value. It can also be expressed by the following formula:
Option contract price = intrinsic value + time value
What is the intrinsic value of an option?
The intrinsic value of an option is how much the option is worth when the option is exercised immediately. For a call option holder, the intrinsic value of the option is only valuable when the current price of the stock (underlying object) is greater than the strike price. This is also called an in-the-money option (In the money). At this time, the call option intrinsic value = stock price - contract strike price; In the same way, for put option holders, the intrinsic value of the option is only valuable when the price of the stock (underlying object) is lower than the strike price, and it is also a real-value option. The intrinsic value of the put option = contract strike price - stock price; when the stock price is greater than the strike price, the put option holder will give up the right to exercise the put option (out of the money). Each option has a corresponding contract multiplier. Usually, in the U.S. market, an option contract represents 100 shares; in China, a 50ETF option represents 10,000 shares.
What is the time value of an option?
The time value of an option is the value of the option minus the intrinsic value, which is the value of the change in the value of the option within a certain period of time. The longer the option contract expiration date, the higher the option time value. Because investors are willing to pay a higher price and wait for the stock to change in a direction that is beneficial to their contract. The closer to the expiration date, the less and less time value, when the expiration date, the time value is 0, and the value of the option is only the intrinsic value. This process is also called the time loss of option value.
It should be noted that the time value of options has a characteristic, the closer the time is to expiration, the faster the loss. Generally speaking, the time value of an option will lose about one-third of its value in the half period before the expiration date, and two-thirds of its value in the second half period. For example, for an option that expires in three months or six months, the time value of the option will be depleted in the last month, as shown in Figure 4-1.
Figure 4-1 The remaining time loss of option value
Let's look at two simple examples below, see Figure 4-2, and continue to take Apple and SSE 50ETF options as examples.
Figure 4-2 Apple (AAPL) Option Prices
Let’s look at the example of Apple first. As of January 27, 2017, the Apple (AAPL) call option with a strike price of $110 is priced at $8.38 (see Figure 4-2). The current price of Apple (AAPL) is $117.26. The option contract price of 8.38 includes two parts: ① 117.26-110=7.26 USD is the intrinsic value of the option; 2 8.38-7.26=1.12 USD is the time value.
Let’s look at another example, the options of SSE 50ETF (see Figure 4-3): the price of the option contract with an exercise price of US$2.25 due at the end of January 2017 is US$0.056, and the current price of SSE 50ETF is US$2.276. The option contract price of $2.276 also includes two parts: ① $2.276-2.25=$0.026 is the intrinsic value of the option; ② $0.056-0.026=$0.03 is the time value of the option.
Figure 4-3 SSE 50etf option price
The deeper the in-the-money option, for a call option, that is, the higher the stock price is than the option strike price, the option price will contain more intrinsic value and less time value, because the option itself is valuable, you only need to pay a small amount of time value, and the option does not need to rely on changes in time to become valuable. In this case, the option price is basically the same as the stock (underlying object) price change. This relationship and change describe the Delta in our Greek alphabet. We will explain more factors that affect option prices when we explain the Greek letters (greeks) in Chapter 2.
In general, option price = intrinsic value + time value. Intrinsic value depends on the reality of the option, so there may or may not be. Time value depends on expiration time and implied volatility (some literature will put option value = intrinsic value + time value + implied volatility value). Time value must exist. The longer the option expires, the greater the time value; the higher the implied volatility, the greater the time value (will be explained in detail later). In addition, the time value can be negative, which occurs in European options. The reason why the time value is negative is due to the impact of stock dividends or the cash cost used for the delivery of the subject matter.
