The Option Premium

Option prices can be decomposed into the option’s intrinsic value and time value.

Intrinsic Value

Intrinsic value is the amount that an option is immediately worth given the relation between the option striking price and the current stock price

Intrinsic value is the payoff value of the option were it possible to exercise immediately; if out of the money, zero, otherwise the difference between the strike and current stock price.

Example:

Let us look at the option prices of Union Pacific Corp. The closing price of UNP was 86.31.

The November 2010, $40 strike call is selling for $47.950. The closing UNP price was $86.31.47.  So $86.31-$40.00=$46.31 is the intrinsic value of the option.

For a call option, intrinsic value = Stock price – Striking price

For a put option, intrinsic value = Striking price – Stock price

Points to remember:

Intrinsic value cannot be less than zero

An option with no intrinsic value is out-of-the-money

An option whose striking price is exactly equal to the price of the underlying security is at-the-money.

Options that are “almost” at-the-money are near-the-money

Time Value

Time value is equal to the premium minus the intrinsic value As an option moves closer to expiration, its time value decreases (time value decay)

An option is a wasting asset.

Example: The November 2010, $40 strike call is selling for $47.950. The closing UNP price was $86.31.47.  So $86.31-$40.00=$46.31 is the intrinsic value of the option. The remaining $1.640 of the option’s price is its time value, i.e. what you’ll pay for the chance that over the next 2 months it’s payoff will increase.  For a deep in the money call option, this is small compared to its intrinsic value.

In comparison, the out of the money $90 option has $0 intrinsic value.  So its $0.790 price is all time value, i.e. the chance that over 2 months the stock price will rise to above $90.