Components of Options Pricing

The total value of an option consists of intrinsic value, which is simply how far in-the-money an option is, and time value, which is the difference between the price paid and the intrinsic value.

Thus, Option Price = Intrinsic Value + Time Value

Components of Options Pricing

Intrinsic Value

The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option.

Both call option and put option have intrinsic value.

1. Intrinsic Value of a Call Option: When the underlying security’s price is higher than the strike price, a call option is said to be “in-the-money.”

2. Intrinsic Value of a Put Option: If the underlying security’s price is less than the strike price, a put option is “in-the-money.”

Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option’s exercise price, or strike price.

The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

Condition Call Put
Strike price < underlying security price In-the-money Intrinsic value > 0 Out-of-the-money Intrinsic value = 0
Strike price > underlying security price Out-of-the-money Intrinsic value = 0 In-the-money Intrinsic value > 0
Strike price = underlying security price At-the-money Intrinsic value = 0 At-the-money Intrinsic value = 0

Time Value

Prior to expiration, any premium in excess of intrinsic value is called time value.

Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value in the hope that at some time prior to expiration, its value will increase because of a favorable change in the price of the underlying security.

It is determined by the remaining lifespan of the option, the volatility, and the cost of refinancing the underlying asset (interest rates). So,

Time Value = Option Price – Intrinsic Value

The option premium is always greater than the intrinsic value. This extra money is for the risk which the option writer/seller is undertaking.

The longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value.

For example,

Option Strike Price  Option Premium Stock Price Intrinsic Value Time Value
Call ₹30 ₹3 ₹29 ₹1 ₹2
Put ₹50 ₹4 ₹52 ₹2 ₹2
Call ₹25 ₹2 ₹25 ₹ 0 ₹2
Put ₹100 ₹6 ₹101 ₹1 ₹5
Call ₹15 ₹1 ₹16 ₹0 ₹1
Put ₹40 ₹18 ₹55 ₹15 ₹3

Example 4: A 2-month call option on Infosys with a strike price of ₹2,100 is selling for ₹140 when the share is trading at ₹2,200. Find out the following:

  1. What is the intrinsic worth of the call option?
  2. Why should one buy the call for a price in excess of intrinsic worth?
  3. Under what circumstances the option holder would exercise his call?
  4. At what price of the asset the call option holder would break even?

Solution:

1. The intrinsic worth of the option is (S – X) = 2,200 – 2,100 = ₹100.

2. The price of the option is ₹140, i.e., ₹40 more than the intrinsic worth.

This is the time value of the option and is paid because there are chances that in the next two months, the price of Infosys may rise further, and the holder stands to gain a greater amount than ₹100, the present intrinsic worth.

3. The option holder would exercise his call if the price of the asset, S > X, the exercise price, i.e., when s > 2,100.

4. Call option holder would break even when pay-off of the call S-X-c = 0, which happens at S = ₹2,240.

Example 5: A 3-month put option on the Tata Steel with a strike price of ₹550 is selling for ₹60 when the share is trading at ₹500. Find out the lowing:

  1. What is the intrinsic worth of the put option?
  2. What is the time value of the put option?
  3. What interrelation can you attach with the time value?
  4. At what price of the asset the put option holder would break even?

Solution:

1. The intrinsic worth of the option is (X – S) = 550 – 500 = ₹50.00.

2. The time value of a put is option price less its intrinsic worth =60-50=₹10.00.

3. The time value is paid by the buyer of the option that the intrinsic value of the option may rise in the future with the fall in the prices.

As the price of the underlying falls, the put option becomes more in the money, and therefore holder stands to gain a greater amount.

4. If the value of Tata Steel shares falls to ₹, 490, the put option holder would get back the entire premium by way of the intrinsic worth of the option.

However, instead of exercising the option, he may like to sell the same as it would fetch a greater value, the time value over and above the intrinsic value.

Leave a Comment

nine − 5 =

error: Alert: Content is protected !!