Every asset has an intrinsic value. For example, in case of an Rs.5 coin, the intrinsic value is the value of the metal in it. This intrinsic value is the embedded value in the asset irrespective of market expectations and government fiat. Similarly, in case of equity shares, the value of the net assets or the present value of the future cash flows can be interpreted as the intrinsic value of the stock. But what is intrinsic value of option? After all, options are just contracts and represent a right without the obligation to buy or sell an asset for stock market trading. How to calculate intrinsic value of option? Above all, how to apply the idea of intrinsic value of option in reality and how it impacts the market price. Let us also understand this intrinsic value versus market value debate.
Intrinsic value of an option: How to calculate it:
Intrinsic value of an option can be defined as the extent to which the option is in-the-money (ITM). What do we understand by ITM options? An ITM option is one where the right implicit in the option is valuable purely because the price is favourable. To understand the concept of intrinsic value one also needs to understand the concept of time value of an option. In fact, it is the sum of the time value and the intrinsic value that represents the market price of the option. Time value, as the name suggests, is the price you pay for the expectation that the option price will move further in your favour. For example, ATM options and OTM options do not have any intrinsic value since there is no price advantage for the option in both the cases. Hence the entire premium of the option represents the time value only. If all that sounds a tad confusing, then let us break up this discussion further into call options and put options and understand the intrinsic value of an option in granular detail.
Intrinsic value of a call option:
A call option is the right to buy an asset without the obligation to buy that asset. You agree to buy the asset at a price which is called the strike price. If the market price is above the strike price, then the call option has a positive intrinsic value. If the market price is below the strike price, then the call option has zero intrinsic value. Look at the formula below..
Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price
Time Value = Call Premium - Intrinsic Value
Let us break down this idea of intrinsic value of call option with a live example of different strikes and correlate with different market prices of the stock. Let us look at the price of Reliance.
Strike PriceCMP - 935Intrinsic ValueTime ValueCMP-955Intrinsic ValueTime Value920 Call261511543519930 Call1257422517940 Call80823158950 Call505954960 Call202606
In the above table, the pink shaded cells represent the out of the money (OTM) call options. In all the OTM options you will find that the intrinsic value of the option is zero and the premium of options is entirely represented by time value (expectations).
Intrinsic value of a put option:
A put option is the right to sell an asset without the obligation to sell that asset. You agree to sell the asset at a price which is called the strike price. If the market price is below the strike price, then the put option has a positive intrinsic value. If the market price is above the strike price, then the put option has zero intrinsic value. Look at the formula below.
Put Options: Intrinsic value = Call Strike Price - Underlying Stock's Current Price
Time Value = Put Premium - Intrinsic Value
The put option payoff will be a mirror image of the call option payoff. Like in case of call options, even in case of put options, the OTM and ATM options will have zero intrinsic value. The only difference is that the intrinsic value of a put option increases as the market price of the stock keeps falling.
How to apply intrinsic value of options to your trading strategy:
Here are 3 basic rules to apply the concept of intrinsic value while trading:
Options that have a very high proportion of intrinsic value are almost akin to trading futures. In that case you can take a call whether you want to trade in a wasting asset or in a futures contract which can be rolled over.
Options with low intrinsic value and higher time value will have a larger propensity to see value shifts when the volatility in the market changes. That is because time value is more susceptible to changes in volatility.
When you pay the option price while buying options, split the price into intrinsic value and time value. Then you get an idea how much you are paying for embedded value and how much you are paying for future expectations of price movement.
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