Intrinsic Value and Time Value

Once you become comfortable with methods of stock selection, you will be ready to use that knowledge to study the options market. Remember that options themselves change in value based on movement in the underlying stock. Because option valuation is inescapably tied to stock value and market conditions, options do not possess any fundamental value of their own. By definition, the fundamentals are the financial condition and results of the corporation; an option is related to the stock's market value and exists only for a brief period of time.

Every listed option and its pricing structure are more easily comprehended by a study of valuation, which has two parts. The first of the two segments of value is called intrinsic value, which is that part of an option's premium equal to the number of points it is in the money. Intrinsic value, for example, is three points for a call that is three points above striking price, or for a put that is three points below striking price. Any option premium above the intrinsic value is known as time value. This will decline predictably over time, as expiration nears. With many months before expiration, time value can be substantial; if the option is at the money or out of the money, the entire premium is time value. As expiration approaches, time value evaporates at a quickening pace, and at the point of expiration, no time value remains. Time value also tends to fall away when the option is substantially out of the money. In other words, an option that is 2 points out of the money will be likely to have greater time value than one with the same time until expiration, but 15 points out of the money. Option valuation can be summed up in this statement: the relative degree of intrinsic value and time value is determined by the distance between striking price and current market value of stock, adjusted by the time remaining until expiration of the option.

The Declining Time Value of an Option

Option Premium (Striking Price of $45)
Month Stock Price Total Value Intrinsic Value Time Value
1 $45 $3 $0 $3
2 47 5 2 3
3 46 4 1 3
4 46 3 1 2
5 47 4 2 2
6 44 2 0 2
7 46 2 1 1
8 45 1 0 1
9 46 1 1 0


Value, but No Real Value: A 45 call is valued currently at 3 ($300 premium value on a $45 striking price). The underlying stock's market value is currently $45 per share. Because the option is at the money, it has no intrinsic value. The entire premium represents time value alone. You know that by expiration, the time value will disappear completely, so it will be necessary for the stock to increase in value at least three points for you to break even were you to buy the call (and without considering transaction fees). The stock will need to rise beyond the threeâ
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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