Options Pricing: Intrinsic Value and Time Value
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There are more factors time value of a call option example time value of an option. Among the most important are time to expirationinterest ratesand moneyness — or whether an option is in the money, at the money, or out of the moneyand how far. Time value of a call option example article deals with the last factor mentioned. What is your total risk what can you lose in the worst case when you own an option? The worst case scenario is that you will be holding the option until expiration and the option will expire worthless.
Market time value of a call option example of every option is the sum of its intrinsic value and time value. When you add up the two, you get your maximum risk. When an option is deep in the moneyyou risk a lot in intrinsic value. For example, you have an option with a strike price of 20 on a stock which currently trades at The intrinsic value of this option is 30 dollars per share and you can theoretically lose this all if the stock falls sharply under So your total risk as the owner of this option is its market price, equal to intrinsic value plus time value.
Now compare this with another option on the same stock, but with the strike price of Because the underlying stock trades also at 50, the option is at the money.
The intrinsic value of this option is zero. Your total risk as the owner of this option is its market price which in this case equals only its time value. Now what would your total risk be in each case? In the at the money option example your total risk would be just the 2 dollars. Is the profit potential of the two options different? Both are call options on the same stock and both time value of a call option example make you a profit if the stock trades above 52 at expiration assuming you would wait till expiration and then exercise the options.
Your total profit from holding the option in both cases is 1 dollar for every dollar by which the price of the underlying stock will exceed 52 market price of the underlying stock at the moment of buying the option plus time value of the option at the moment of buying the option.
So what would you prefer to do? Risk 32 dollars or risk 2 dollars if the profit potential is time value of a call option example same in both cases?
Of course every rational person would prefer to risk less. This is why in reality the time value of the at the money option would be higher than the time value of the deep in the money option. People are willing to pay an extra price in the time value for reducing their risk. Consider buying the stock itself instead of buying the options. A stock has no time valueas there is no optionality in it.
In fact a stock is like a call option with a strike price of zero and the underlying asset is the stock itself. If you own a stock, your maximum risk is its market price. You can look at long stock as an extremely deep in the money call option with zero strike and zero time value.
The reason is that the ratio of expected profit to maximum risk is the best here and therefore the benefit from having the choice to exercise or not is the greatest here. For in the money call optionsthe closer an option is to a long stock position — this means the lower its strike price is — the smaller its time value will be.
The time value will increase as the option gets closer to the at the money area. If you don't agree with any part of this Agreement, please leave the website now.
All information is for educational purposes only and may be inaccurate, incomplete, outdated or plain wrong. Macroption is not liable for any damages resulting from using the content. No financial, investment or trading advice is given at any time.
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