How to Calculate the Intrinsic Value of a Stock Option?

The intrinsic value of a stock option is the theoretical profit of the option. However, a stock option also has extrinsic value.

Let us discuss what is the intrinsic value of a stock option and how to calculate it.

Intrinsic Value of Stock Options

The intrinsic value of a stock option is the value or price of the options contract at any given time.

It is simply the fundamental or true value of an options contract. It is the amount of profit in a stock option that an investor would receive by selling the contract right away.

The total value of an options contract comprises intrinsic and extrinsic values. The extrinsic value changes with time decay.

Stock options are derivatives. It means their prices follow the price movements of underlying assets (stocks). An investor of stock options holds the right to buy or sell underlying stocks at a strike price on or before the expiry date.

Therefore, there will be a difference between the strike price and the market price of stock options most of the time. If the price difference is favorable for the investors, the option is supposed to be in the money.

If there is no profit and also no loss, the option is at the money. Similarly, if the options contract has only loss, it is out of the money.

Therefore, the investors must know the moneyness of the stock options at all times. The difference between the strike price and the market price will be the intrinsic value of the option if any.

Only in the money stock options are profitable and have intrinsic values. It means at the money and out of the money stock options do not have intrinsic values.

The intrinsic value of a stock option cannot be a negative number. If there is no profit, the intrinsic value of a stock option is zero.

How to Calculate the Intrinsic Value of Stock Options?

The first step in calculating the intrinsic value of stock options is to determine the moneyness of the options contract.

As mentioned above, only in the money stock options will have intrinsic value. Then, an investor may hold a call or put option.

Then, for a call option, you’ll deduct the current stock price from the strike price of the option. Conversely, for a put option, you’ll deduct the strike price from the current market price of the stock.

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Essentially, the intrinsic value is the difference between the strike price and the market price of the stock for both types of options contracts.

Formula

The formula to calculate the intrinsic value of the call option can be written as:

Intrinsic value of a call option = Current Stock Price – Call Strike Price

Similarly, for a put option, the intrinsic value will be:

Intrinsic value of a Put Option = Put Strike Price – Current Stock Price

Simply put, the difference between the strike price of a stock option and the current stock price is the intrinsic value or profit of the contract.

Example

Suppose a stock ABC is currently selling at $ 40. An investor holds a call option for ABC stock with a strike price of $35.

Therefore, the intrinsic value of the call option will be:

Intrinsic Value of Call Option = Current Stock Price – Strike Price

Intrinsic Value of Call Option = $40 – $35 = $5.

It means the call option is in the money or it has an intrinsic value of $5 currently.

Now, suppose the stock price of ABC Company falls below the strike price and is currently trading at $30. Then,

Intrinsic Value of Call Option = Current Stock Price – Strike Price

Intrinsic Value of Call Option = $30 – $35 = -$5

It means the call option is out of money and has no intrinsic value.

Suppose the investor holds a put option of ABC stock with the same stock price of $40 currently.

Assume that the strike price of the ABC stock option is $45. Then,

Intrinsic Value of Put Option = Strike Price – Stock Current Price

Intrinsic Value of Put Option = $45 – $40 = $5

The put option is in the money and it has an intrinsic value of $5. The put option will be out of the money if the stock price moves to $45 and beyond.

Stock Options Pricing

A stock option can be in the money, at the money, and out of the money depending on the strike price and the stock price movements.

For a call option to be in the money, the strike price of the options contract must be lower than the stock price. Conversely, when the stock price of a company surpasses the strike price of the option, it creates intrinsic value.

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When the strike price and the stock prices are at the same point, there is no intrinsic value. The options are said to be at the money for calls and puts.

When the stock price of the company is below the strike price, it is said to be out of the money for a call option.

The moneyness of the put options works conversely to the call options.

Let us understand the moneyness or intrinsic value of the stock options with the help of a simple price chart.

Suppose a stock ABC is currently trading at $50. Investors of call and put options can calculate the intrinsic values as below.

Strike Price$35$40$45$50$55$60$65
Type       
Call$15$10$5$0$0$0$0
Put$0$0$0$0$5$10$15

As we can see, the intrinsic value of the call and put options work in opposite directions. Investors can use put and call options for speculations, hedging, and other purposes by combining them in their portfolios.

Extrinsic Value of a Stock Option – Time Value

The time value of a stock option is an important concept in options pricing.

Since the options contract gives a right to buy or sell stocks, investors can trade options at any time before the expiry date. It means when there is more time left to trade options, the time value of these contracts will be higher.

Therefore, the intangible value of a stock option will increase if it has longer validity. That is called the extrinsic value of a stock option.

In our discussion above, we have so far ignored the actual cost of owning a stock options contract. The writers of the options contract willingly take risks. Therefore, they ask for premiums on top of the theoretical value of options.

The extrinsic value of the stock options is the time value or the premium of the stock option. It is simply the intangible part of the total profit of an options contract.

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The Total Value of a Stock Option

Theoretically, the total value of a stock option is the sum of its intrinsic and extrinsic values.

In practice, a stock option may have zero intrinsic value but still be profitable and vice versa. Also, a stock option may have zero extrinsic value but may still have intrinsic value theoretically.

Suppose a call option has a strike price of $70. The underlying stock ABC is trading at $75. Therefore, the intrinsic value of the stock is $5.

Now suppose the call option has a premium of $5 in it. Therefore, the total value of the ABC stock option is zero. It means the ABC stock option is currently at the money.

For at the money and out of the money options, there is no intrinsic value. The total value of these contracts is made up of extrinsic values.

Importance of the Intrinsic and Extrinsic Values of a Stock Option

The intrinsic value is the theoretical profit of a stock option. However, it is only the base profit. Investors are typically willing to pay more for options than their intrinsic value.

Why? Simply because if there is sufficient time left, the derivative can increase its value. Therefore, the investors take risks to invest in options in anticipation of favorable price movements later.

That’s the prime reason why the time value or the extrinsic value of a stock option is important. In practice, the larger proportion of the total profit of a stock option comprises the extrinsic value.

Also, time value or the extrinsic value is the driving force behind the bid-ask spread for options contracts. It keeps the market makers in the market and helps keep the liquidity of the market.

The moneyness of a stock option is also linked with the time value. For instance, an out-of-the-money option will have a greater impact on extrinsic value than an in-the-money contract.

In short, the intrinsic and extrinsic values of stock options play vital roles in determining the profitability of these derivatives.

Therefore, investors can align their investment strategies by calculating the intrinsic and extrinsic values of stock options at different stages of moneyness and time value.

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