InvestorQ : How is intrinsic value of an option different from the time value? What is their significance?
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How is intrinsic value of an option different from the time value? What is their significance?

Answer
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2 years ago


To understand the concept of time value, you need to first understand the 3 sub-categories of options as under…

In-The-Money (ITM) option is an option contract with a positive intrinsic value. In case of a call option on the Nifty it will be ITM if the market price is greater than the strike price. If the 9800 Nifty call option is trading in the market at Rs.70 and if the spot Nifty is at 9850 then the intrinsic of the Nifty call will be Rs.50 (9850-9800). The time value of the option will be the residual value which is Rs.20 (70-50). So out of the option premium quoting in the market at Rs.70, intrinsic value accounts for Rs.50 and time value accounts for the balance Rs.20. In case of a put option, it will be ITM if the spot price of the Nifty is below the strike price of the put option.

At the money (ATM) option is an option contract with an intrinsic value of zero. In the case of a call option on the Nifty, it will be ATM if the market price is equal to the strike price. Since the intrinsic value is zero, the entire value of the option will be the time value.

Out-of-the-Money (OTM) options is an option contract where the market price is lower than the strike price in case of a call option and the market price is higher than the strike price in case of a put option. Mathematically, the intrinsic value as per our formula will be negative but since intrinsic value cannot be technical vale cannot be negative we will consider it as zero. The entire option premium, therefore, will be Time Value only.

theta.PNG

As the above chart highlights, it is ATM options that offer the highest time value in the beginning of the month followed by ITM options and then by OTM options. Eventually, the time value in case of all the 3 options will eventually tend towards zero as expiry approaches. While the OTM option and the ATM option itself will have a zero value, in case of ITM options the option premium will still be positive due to the existence of intrinsic value.