As you know, there are a lot of different options words, such as delta or theta, in-the-money, out-of-the-money, intrinsic value, extrinsic value, etc.
But in these segments, we try to demystify options by explaining the terminology, going over different strategies and this kind of thing.
And today, we’re going to talk about intrinsic value.
Intrinsic Value
Everybody knows what intrinsic means in regular everyday life: real, innate, inherent, of within.
In options, the concept is the same.
The definition of intrinsic value as it pertains to options is: the difference between the underlying stock price and the option’s strike price (that’s in-the-money).
For example: if a stock was trading at $50, and a $45 call option with 30 days of time left on it was selling for $6.50, that option would have $5 of intrinsic value.
$50 stock price – $45 call option = $5. If the option premium is worth $6.50, then $5 of that is intrinsic value.
The other $1.50 of that is extrinsic value, also known as time value.
Extrinsic Value (aka Time Value)
Extrinsic value is the amount of the premium that’s not comprised of intrinsic value. This part of the premium is said to be your ‘time value’. Out-of-the-money options are comprised of only time value.
Using the same example as above:
$6.50 premium – $5 intrinsic value = $1.50 of extrinsic value.
So the key thing to remember is that options are comprised of two parts: intrinsic value and extrinsic value, i.e., time value.
So what’s the difference for the investor?
In the beginning, for all practical purposes, nothing.
If I bought an option at $500 and then sold it for $800: whether half of that was comprised of intrinsic value or none of it was comprised of intrinsic value, it makes no difference from that standpoint.
But ultimately, at expiration, when there’s no time left on the option, your option’s sole value will be its intrinsic value.
So at that point it makes all the difference.
For example: if I had a $50 call option with 2 months of time on it and the price of the underlying stock was at $45, that option might be worth $3.50 or $350. And at that point, the premium is comprised on only time value.
But now – fast forward two months – if that stock is still at $45, that option is $5 out-of-the-money, meaning it has no intrinsic value. And since its expiration, the time has run out, which means there’s no time value, which also means that option is worthless.
If on the other hand, the stock was at $53 at expiration, it’s now $3 ‘in-the-money’. All of the time value has disappeared. But it’s now got $3.00 of intrinsic value (because it’s $3 ‘in-the-money’), which means your option is worth $300 if you were to sell it.
Understanding intrinsic value is important so you can determine potential profit and loss scenarios with your options strategies.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our new Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
