Are you into option trading? If Yes, understand the mathematics of intrinsic and time value

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Most of the new investors and traders in the options market prefer to buy Calls or Puts because of unlimited returns with limited risk. Investors use options trading for short term profits. To buy an option contract, traders pay a premium which is used to make profits. So it is important to understand the intrinsic value and time value of an option.

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Before understanding time value, let us talk about intrinsic value. Intrinsic value in an option contract usually refers to the market value of the contract. Intrinsic value refers to how much ‘in-the-money’ is currently in the contract. ‘In the money’ means that the price of the underlying asset is higher than the strike price. In an option contract, the price at which the two parties agree to buy or sell the underlying asset is called the strike price.

For example, if you have an option contract with a strike price of Rs 200, which is currently priced at Rs 300. The intrinsic value of this call option would be Rs 100 (300-200). That is, when the price of the underlying asset is less than the strike price, the intrinsic value will be zero, as no buyer would want to complete the deal when he is incurring a loss.

What is the time value of an option contract? Time value is the additional amount that the buyer has to pay over and above the intrinsic value till the expiry of the contract. This amount is received by the option seller for giving the option or right.  With expiry of option contract extending, the price of time value also increases. The more an option contract is past its expiration date, the more likely it is that the price of the underlying asset will be higher than the strike price or move to the buyer’s preferred location. For example, if the expiry of one option is three months and the expiry of the other option is two months, then the time value of the first option will be more.

The buyer pays a premium to the seller for availing the option contract. The premium has two components – intrinsic value and time value. In order to arrive at the time value price, option premium has to be deducted from the intrinsic value… For example, suppose the premium for the earlier mentioned Rs 200 option contract was Rs 150, while the intrinsic value was Rs 100. In such a situation, the time value will be Rs 50 (150-100).