Price and Time Value

We ended our previous lesson with a mention of price and time value. In the world of options we also have additional terminology to describe these different situations:

 Time Value: This is the part of the value (premium) of the option, that it has because of “the chance, that in the time left until expiry, it COULD reach the strike price (or in our second example, move even higher up in value).”

 Intrinsic Value: This is the part of the value (premium) of the option, that it has because the price of the underlying already exceeded the strike price. With our 77 strike option, this was zero but with our 73 strike option, this was 2.2 points. Viewed differently, the intrinsic value would be the value you will realise if you exercised your option immediately.

Total Value (Premium): Premium = Intrinsic Value + Time Value

 When you Exercise: You only realise the Intrinsic Value part of the premium!

Out of the Money (OTM): We use this term to describe an option for which the Intrinsic Value part is zero. It only has time value, if exercised right now it would actually be worthless.

 In the Money (ITM): We use this term to describe an option for which the Intrinsic Value part is positive, it already has value, if exercised right now you will get at least something for the option.

 At the Money (ATM): We use this to describe an option that is about to enter into the money, it is right at the point to start building intrinsic value, or it has just moved into the money. In other words, the price of the market is right at – just below, or just above – the strike price of the option.

 Far Out the Money (FOTM): “Far” is in the eye of the beholder, what is far for one person might not be far for you. But this term is used to describe an option where there is still a considerable distance between the market price and the option strike price and the market has to move quite a distance before threatening the strike price of the option.

 Deep in the Money (DITM): “Deep”, as above, is in the eye of the beholder. We use this term to describe an option where the price of the underlying has gone far above (below for a Put option) the strike price – there is a lot of Intrinsic Value in the option!


So when we say – “..an option is moving into the money..” – it is actually a bit misleading. The option’s strike price is fixed, it cannot move anywhere! What IS moving is the underlying price of the market and as the market price starts to go above the strike price (for a call option, below the strike price for a put option), we are saying that the option is moving into the money, in other words, the option is starting to gain some intrinsic value because of the movement of the underlying market.


Note:

1. Time value will ALWAYS exist as long as there is time left for prices to move. It will never be zero but Intrinsic Value will only exist if the price of the underlying exceeds the strike price.

2. When you EXERCISE an option, the only value that you will realise is the Intrinsic Value. THUS NOW, which is better? More value – to sell the option onto someone else or to exercise the option? Perhaps now you will understand why option buyers never exercise, until the last day – they can get more for the option by selling it to someone else than to exercise! (Which is not necessarily the right way to do it, but we’ll discuss that later).