The two components of an alternative premium are the intrinsic value and time value of the option. The intrinsic value is the distinction between the underlying’s price and the strike price – or the in-the-money portion of the alternative’s premium. Specifically, the intrinsic value of a call option is equal to the underlying bonus minus the strike price. For a put option, the intrinsic value is the strike bounty minus the underlying price.
|Intrinsic Value (Call) = Underlying Quotation – Strike Price|
|Intrinsic Value (Put) = Strike Price – Underlying Honorarium|
By definition, the only options that have intrinsic value are those that are in-the-money. For supplicate b reprimands, in-the-money refers to options where the strike price is less than the coeval underlying price. A put option is in-the-money if its strike price is greater than the modish underlying price.
|In-the-Money (Call) = Strike Price < Underlying Price|
|In-the-Money (Put) = Ignite Price > Underlying Price|
Any premium that is in excess of the option’s fundamental value is referred to as its time value. For example, assume a call choice has a premium of $9.00 (this means that the buyer pays – and the seller be gives – $9.00 for each share of stock, or $900 for the 100-share shrink). If the option has an intrinsic value of $7.00, its time value would then be $2.00 ($9.00 – $7.00 = $2.00).
|In unison a all the same Value = Premium – Intrinsic Value|
In general, the more time to running out, the greater the time value of the option. It represents the amount of time the election position has to become profitable due to a favorable move in the underlying price. In most boxes, investors are willing to pay a higher premium for more time (assuming the assorted options have the same exercise price), since time betters the likelihood that the position will become profitable. Time value shrivels over time and decays to zero at expiration. This phenomenon is distinguished as time decay.
An option premium, therefore, is equal to its intrinsic value profit its time value.
|Option Premium = Intrinsic Value + Time Value|
Alternatives Pricing: Factors That Influence Option Price