Intrinsic and time value

Over the next few posts we will look at some aspects of option valuation and option Greeks.   This first post revisits a couple of valuation principles that are relevant to the discussion.

In the attached diagram, we use Tesla as an example assuming a current share price of \$1,000.  The diagram shows the at expiry and pre-expiry values of a cash -settled ATM call option with a maturity of 3 months.  An implied volatility of 60% returns a premium of \$120 / share.

At expiry the value of the option is represented by the expression:

MAX (underlying price – strike,0)

This is sometimes termed ‘intrinsic value’

If the share price rises to \$1,100, the option buyer will receive \$100.  A fall to \$900 would result in no payment as it is deemed to have zero intrinsic value.  This expression explains the dark blue horizontal line to the left of the strike and the 45 degree line to the right.

Notice that prior to expiry the value of the option has some degree of curvature shown by the light blue curve.  We know that if the underlying price does end up at \$900 the option would be worthless at expiry but, if shortly after the trade is executed, the underlying price trades down to this level, the option will be worth about \$71.  So in option speak the option has ‘time value’ of \$71.  Think about this as the potential intrinsic value – the option buyer is asking ‘how much do I see myself making from now until maturity’?

The premium on an option is made up of intrinsic and time value.  So for our Tesla call with a strike of \$1,000:

Spot price \$900?  Premium is \$71 and is all time value

Spot price \$1,000?  Premium is \$120 and is all time value

Spot price \$1,100? Premium is \$183 and is made up of \$100 of intrinsic and \$83 of time value.

Understanding these fundamental concepts gives us insight into the nature of option trading.  What impacts intrinsic value?  Movements in the underlying price.  What impacts time value? Take it on trust that this implied volatility and the passage of time.

So when trading options we need to take a view on direction and volatility as well as appreciating that time will impact the value of our position.  Don’t make the rookie mistake of thinking that options can only be used to take a view on the asset’s direction.