In our last Foundations of Trading Options blog, we explained the bid price, ask price, last price, and strike price when it comes to buying and selling options. Today, we are still reviewing class two as we look deeper into the value of an option. The worth of an option can be divided up into two pieces: Intrinsic Value and Time Value. And before we continue this discussion any further, here is a brief reminder when working with options.
In short, intrinsic value is a measure of how much the strike price of an option is worth. For example, if you have the right to buy, using a call option, a stock at $90 and the stock is trading at $100, then that call option has $10 of intrinsic value attached to it. Because you could exercise your right to buy at $90 and then turn around and sell the stock on the market at $100, thus earning $10 per share. On the other side of the coin, if you have the right to buy at $90 but the stock is trading at $85, then that option has no intrinsic value as it cannot be a negative number.
Now, when an option has intrinsic value, it is commonly referred to as being “In The Money.” And to cover both sides of the proverbial coin, when an option has no intrinsic value, we say it is “Out of the Money.” At the Money or Near the Money options are those contracts whose strike prices are closest to the current market price of the underlying security. Call options, for example, are In the Money when the strike price is less than the stock price, while put options are In the Money when the strike price is greater than the stock price.
Time value is the dollar amount that the market maker is assigning to the time remaining until the option expires. It should be noted that the more time that is left until the option expires, the more valuable the time portion is. That’s because there is more time for the underlying security to move in a favorable direction. So every day the option gets close to expiration, it will lose some of its value. This effect is known as Time Decay, and as time draws closer to the expiration date of an option, the time value of an option will decay to zero, and all that will be left is any remaining intrinsic value. It is important to understand that even though time moves linearly, time decay moves exponentially, as it is demonstrated in the following image.
In Closing, intrinsic value and time value are important concepts to understand when dealing with options. And if you have any questions regarding this blog or any of the content which Chris has presented in his current options classes, please stop by to see our teachers and moderators in our Group Coaching sessions which happen every Thursday. Contact Rebekah at firstname.lastname@example.org for details on Group Coaching sessions. Take care, and we will see you guys back this time next week!