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In finance, the value of an option consists of two components, its intrinsic value and its time value. Time value is simply the difference between option value and intrinsic value. Time value is also known as extrinsic value, or instrumental value.
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Intrinsic value
Intrinsic value is the greater of zero and the difference between the exercise price of the option (strike price, K) and the current value of the underlying instrument (spot price, S); see formulae below. If the option does not have positive monetary value, it is referred to as out-the-money. If an option is out-the-money at expiration, its holder will simply "abandon the option" and it will expire worthless. Because the option owner will never choose to lose money by exercising, an option will never have a value less than zero.[1]
- For a call option: value = Max [ (S – K), 0 ]
- For a put option: value = Max [ (K – S), 0 ]
As seen on the graph, the call option's intrinsic value begins when the underlying asset's spot price exceeds the option's strike price.
Option value
Option value (i.e. price) is found via a formula such as Black-Scholes or using a numerical method such as the Binomial model. This price will reflect the "likelihood" of the option finishing "in-the-money". For an out-the-money option, the further in the future the expiration date - i.e. the longer the time to exercise - the higher the chance of this occurring, and thus the higher the option price; for an in-the-money option the chance in the money decreases; however the fact that the option cannot have negative value also works in the owner's favor. The sensitivity of the option value to the amount of time to expiry is known as the option's "theta"; see The Greeks. The option value will never be lower than its intrinsic value.
As seen on the graph, the full call option value (intrinsic and time value) is the red line.
Time value
Time value is, as above, the difference between option value and intrinsic value, i.e.
Time Value = Option Value - Intrinsic Value.
More specifically, an option's time value reflects the probability the option will gain in intrinsic value or become profitable to exercise before it expires[2]. An important factor is the options volatility. Volatile prices of the underlying option can stimulate option demand, enhancing the value. Numerically, this value depends on the time until the expiration date and the volatility of the underlying instrument's price. The time value of an option is not negative (because the option value is never lower than the intrinsic value), and converges towards zero with time. At expiration, where the option value is simply its intrinsic value, time value is zero. Prior to expiration, the change in time value with time is non-linear, being a function of the option price.[3]
See also
References
- ^ Understanding Option Pricing Hans Wagner
- ^ Option premium valuation 22 August 2007
- ^ Options: Time Value, wolfram.com
External links and references
- Basic Options Concepts: Intrinsic Value and Time Value, biz.yahoo.com
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