Know about time value of option and what intrinsic value in options is

Options trading can be complex and involves a high level of risk. It is important for traders to thoroughly understand the terms and conditions of an options contract before entering into a trade. By carefully considering the intrinsic value, time value, and other factors, traders can increase their chances of success in the options market.

The time value of option is the sum by which the option's premium exceeds its intrinsic value. It represents the potential for the option to increase in value due to the passage of time, changes in the underlying asset's price, or changes in market conditions. The time value decreases as the option approaches expiration because there is less time for the option to appreciate. In this article, we are going to learn about the intrinsic value of options, option time value, and how to measure the intrinsic value of options. 

This article covers: 

• What is an option contract?
• What is Intrinsic Value in Options Contract?
• What is the Time Value of Options Contract?
• How does Time Value work in Options?
• How to measure the Intrinsic value of Options?

What is an option contract?

An option contract is a contract between two parties where one party has the right, but not the obligation, to purchase an asset at a certain price within a set period of time. This allows the party with the right to purchase the asset to lock in the price before it changes and gives them peace of mind that they will be able to purchase the asset at a predetermined price.

There are three types of options contracts: calls, puts, and straddles

1. Call option: The holder of a call right has the right, but not the obligation, to buy a security (for example stocks, commodities, and currencies) from the issuer at a set price within a specific period. 
2. Put option: A put gives the buyer the right to sell the security at the set price by a certain date or within a certain period. The purpose of a put option is to protect against a decline in the price of a security or commodity. 
3. Straddle: A straddle gives the buyer both call and put options on the same security. This allows the investor to profit if the price of the security goes up or down, but also protects them in case the price of the security does not change.

Key takeaways:

• The time value of an option is determined by how much the security is worth, relative to what it cost to purchase it.
• Time value is an important factor to consider when trading options. 
• It's important to note that the time value is not constant and can change over time. 
• Factors that can impact the time value of an option include changes in the price of the underlying asset, changes in market volatility, and changes in interest rates. 

What is Intrinsic Value in Options Contract?

The intrinsic value of an option is the distinction between the strike price and the current market price of the underlying asset, as long as the market price is above the strike price for a call option or lower than the strike price for a put option. 

For example, if you have a call option with a strike price of Rs. 100 on a stock that is trading at Rs. 110, the intrinsic value of the option would be Rs. 10 (Rs. 110 - Rs. 100). 

It is important to keep in mind that the intrinsic value is only one component of the total value of an options contract. The other component is the time value, which represents the potential for the option to increase in value due to the passage of time, changes in the underlying asset's price, or changes in market conditions.

What is the Time Value of Options Contract?

The time value of an options contract represents the potential for the option to increase in value due to the passage of time, changes in the underlying asset's price, or changes in market conditions. It is the sum by which the option's premium exceeds its intrinsic value.

The time value of an option decreases as the option approaches expiration because there is less time for the option to appreciate. For this reason, options with longer expiration dates tend to have higher time values than those with shorter expiration dates. So, options traders need to consider the time value of an option when making a trade, as it can affect the potential profitability of the option and the risk involved in the trade. Options traders may use various strategies to take advantage of the time value of an option, such as selling options with high time value or using time value to their advantage in spread trades.

How does Time Value work in Options?

The time value of an options contract is the distinction between the option's premium and its intrinsic value. You can use the formula you provided to calculate the time value of an options contract:

Time Value = Option Premium - Intrinsic Value

For example, if you have a call option with a strike price of Rs. 100 and a premium of Rs. 15, and the underlying asset is trading at Rs. 110, the intrinsic value of the option would be Rs. 10 (Rs. 110 - Rs. 100). The time value of the option would then be Rs. 5 (Rs. 15 - Rs. 10), representing the potential for the option to increase in value over time.

The time value of an option is an important consideration for options traders because it can affect the potential profitability of the option and the risk involved in the trade. Options with higher time values tend to be riskier because there is more uncertainty about the potential for the option to increase in value. On the other hand, options with lower time values tend to be less risky because there is less time for the option to appreciate. However, It is important for options traders to carefully evaluate the time value of an option before making a trade, as it can have a significant impact on the outcome of the trade.

How to measure the Intrinsic value of Options?

You can use the following formula to calculate the intrinsic value of an options contract:

Intrinsic Value = Option Premium - Time Value

• Options traders need to understand the intrinsic value of an option because it represents the amount by which the option is in-the-money. This can help traders determine the potential profitability of an option and assess the risk involved in the trade.
• It is also important to keep in mind that the intrinsic value is only one component of the total value of an options contract. The other component is the time value, which represents the potential for the option to increase in value due to the passage of time, changes in the underlying asset's price, or changes in market conditions. Both the intrinsic value and the time value can affect the price of an options contract.

Conclusion

Understanding the intrinsic value and time value of options is important for options traders because they can use this information to determine the potential profitability of an option and assess the risk involved in the trade. It can also help traders determine the appropriate strategy to use, such as whether to hold the option until expiration or to close the position before expiration. However, traders need to keep in mind that they should always analyze the trading objective and risk appetite before trading options.