The premium is the current market price of an options contract. Like any market price, it’s influenced by supply and demand:
Market demand for an options contract is generally driven by two components: intrinsic value and time value.
Intrinsic value is the amount of profit the holder would have if the option were exercised immediately. For example, an option that gives you the right to buy a stock at $50 when the stock is trading at $60 has $10 of intrinsic value. In general, the more intrinsic value an option has, the higher its premium tends to be.
Time value reflects how much time is left until the option expires. More time means more opportunity for the market price to move in a favorable direction. Because of that added opportunity, options with more time remaining generally have higher premiums.
Option premiums can be calculated using this formula:
Intrinsic value is also called the “in the money” (ITM) amount of the contract. An option is in the money when exercising it would produce a positive return for the holder.
You can summarize how intrinsic value works for calls and puts like this:
Calls:
Go in the money (gain intrinsic value) when the market rises
Go out the money (lose intrinsic value) when the market falls
Puts:
Go in the money (gain intrinsic value) when the market falls
Go out the money (lose intrinsic value) when the market rises
To represent this visually:
| Market | Calls | Puts |
|---|---|---|
| ITM | OTM | |
| — | ATM | ATM |
| OTM | ITM |
If a contract is in the money, it has intrinsic value. If a contract is out of the money, it has no intrinsic value. A contract is at the money when the strike price and market price are the same.
Market prices fluctuate daily, so an option can move in and out of the money many times before expiration. A lot can change in the nine months* that options exist, which is why time value is such an important part of an option’s premium.
*Standard options maintain expirations of up to nine months from issuance. However, LEAPS options maintain expirations of up to 3 years from issuance.
Calculating intrinsic value is straightforward once you know three things:
Let’s walk through a few examples.
1 ABC Jan 50 call when the market price is $55
This option has $5 of intrinsic value (it’s “in the money” by $5). Now try a few on your own.
1 ABC Jan 50 call when the market price is $70. How much intrinsic value does the option have?
$20 of intrinsic value (“in the money” by $20)
1 ABC Jan 50 call when the market price is $40. How much intrinsic value does the option have?
No intrinsic value (“out the money” by $10)
1 ABC Jan 50 call when the market price is $50. How much intrinsic value does the option have?
No intrinsic value (“at the money”)
A call’s intrinsic value depends on ABC’s market price relative to the $50 strike price:
Some test takers remember this with the phrase “call up.”
Notice that we haven’t talked about the premium yet. Also, being “in the money” or “out of the money” doesn’t automatically mean you’ve made or lost money on the trade. Intrinsic value only describes the option’s immediate exercise value. Your overall gain or loss depends on the full picture, including the premium you paid or received.
Now let’s look at puts using similar numbers.
1 ABC Jan 50 put when the market price is $55
This option has no intrinsic value and is “out of the money” by $5. Try a few more.
1 ABC Jan 50 put when the market price is $70. How much intrinsic value does the option have?
No intrinsic value (“out of the money” by $20)
1 ABC Jan 50 put when the market price is $40. How much intrinsic value does the option have?
$10 intrinsic value (“in the money” by $10)
1 ABC Jan 50 put when the market price is $50. How much intrinsic value does the option have?
No intrinsic value (“at the money”)
A put’s intrinsic value depends on ABC’s market price relative to the $50 strike price:
Some test takers remember this with the phrase “put down.” As you can see, puts move opposite calls.
Intrinsic value is one part of the premium; time value is the other. The more time an option has until expiration, the more opportunity the stock price has to rise above or fall below key levels.
Assume you can choose between buying an option expiring in one week versus an option expiring in nine months. If both cost the same, the nine-month option would be more attractive because it gives the contract more time to go in the money and gain intrinsic value.
That’s not the real world, though. A nine-month option is typically worth more than a one-week option (assuming the same option type and strike price). From the writer’s perspective, a longer-lived option creates more risk, so writers demand higher premiums. Bottom line: the longer the time until expiration, the more expensive the option tends to be.
Time value can’t be calculated directly without more advanced formulas. However, you can find an option’s time value using simple algebra and the premium formula:
Let’s look at some examples.
1 ABC Mar 35 call @ $5 when ABC’s market price is $36. What is the intrinsic value and time value?
Can you figure it out?
The option has $1 of intrinsic value (“call up”). To find the time value:
In summary:
If you purchased this call for $500 ($5 x 100 shares), $100 ($1 x 100 shares) pays for the immediate benefit provided by intrinsic value. The remaining $400 ($4 x 100 shares) pays for time, which gives the market price a chance to rise further.
Let’s try another:
1 ABC Dec 70 call @ $3 when the market price is $68. What is the intrinsic value and time value?
The option has no intrinsic value (“out of the money”). To find the time value:
In summary:
When an option has no intrinsic value, the premium is entirely time value. If you purchased this option, you wouldn’t be paying for any immediate exercise benefit. The $300 premium ($3 x 100 shares) pays only for time, which gives the market price a chance to rise above $70.
How about this one?
1 ABC Apr 95 put @ $9 when the market price is $92. What is the intrinsic value and time value?
The option has $3 of intrinsic value (“put down”). To find the time value:
In summary:
If you purchased this put for $900 ($9 x 100 shares), $300 ($3 x 100 shares) pays for the immediate benefit provided by intrinsic value. The remaining $600 ($6 x 100 shares) pays for time, which gives the market price a chance to fall further.
Last one.
1 ABC Aug 20 put @ $4 when the market price is $21. What is the intrinsic value and time value?
The option has $0 of intrinsic value (“out of the money”). To find the time value:
In summary:
Again, when an option has no intrinsic value, the premium is entirely time value. If you purchased this put, you wouldn’t be paying for any immediate exercise benefit. The $400 premium ($4 x 100 shares) pays only for time, which gives the market price a chance to fall below $20.
When an option is in the money, holders may consider exercising the contract. Exercising usually involves a quick phone call or an online request. However, not every option can be exercised at any time. Options have two different exercise styles: American and European.
American style options allow exercise to occur at any time. Equity (stock) options are American-style.
European style options only allow exercise to occur at expiration. Index options, which derive their value from fluctuating index values, are almost always European-style. This style of option was introduced to reduce the anxiety of option writers. Although an option may go in the money, the writer knows they don’t need to be concerned about an exercise until expiration.
American and European-style options only relate to the ability to exercise a contract. Both allow option trades to occur at any time leading up to expiration. Therefore, an investor who wants to “get out” of a European-style option does not necessarily need to wait until expiration. They can simply perform a closing transaction!
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