When trading options, it's important to understand these two
definitions.
It could mean the difference between making money and losing money.
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, that means $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:
A $6.50 premium - $5 intrinsic value = $1.50 of extrinsic value.
So the key 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 of 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 it's now expiration, the time has run out, which
means there's no time value either, which also means that option is
worthless.
On the other hand, if the stock was at $53 at expiration, the
option is 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.
And that's why I like to buy my options with intrinsic value to
begin with (i.e., in-the-money options). If your options are
comprised on only time value, you'll need to see a move
commensurate to twice what you paid for the option come expiration
just to break even.
But if your option is comprised of both intrinsic value and time
value, now you'll only need to see the stock go up as much as your
time value cost to breakeven.
Better yet, if the stock does nothing at expiration, I'll get most
of my money back if it's comprised mostly of intrinsic value.
But if it's comprised of only time value, I could lose it all, even
it goes up to the out-of-the-money strike.
So understanding intrinsic value is important in order to determine
your 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
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.
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