Option Price Components (Part 1)

The price of an option consists of 2 main components:
Intrinsic Value and Time Value (Time value is also known as Extrinsic Value).

OPTION PRICE = INTRINSIC VALUE + TIME VALUE

Intrinsic Value is the value that is already built into the option the moment you bought it. Or in other words, the value by which an option is "in-the-money".
Time Value is the difference between an option’s price and its intrinsic value. As the option nears expiration, the time value erodes and eventually becomes zero.

Only In-the-Money (ITM) option has intrinsic value.
For At-The-Money (ATM) and Out-Of-The-Money (OTM) options, the intrinsic value is zero, therefore the option price comprises of only time value. Therefore:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

HOW TO CALCULATE INTRINSIC VALUE & TIME VALUE:

Intrinsic Value of ITM Call Option:
Intrinsic Value = Current Stock Price – Strike Price.

Intrinsic Value of ITM Put Option:
Intrinsic Value = Strike Price – Current Stock Price.

Time Value of All Options (ITM, ATM, OTM):
Time value = Option price – Intrinsic Value (if any)

As a result, the deeper we move into the money, the higher the option price will be (as it has more intrinsic value). The further we go out of the money, the cheaper the option price would be.
The option prices will change throughout the trading day based on the underlying stock movement, volatility and time.

Continue to “Part 2”