How to Distinguish Between the Intrinsic Value & the Fair Value of an Option

Trading action keeps option prices in line with theoretical fair values.

Trading action keeps option prices in line with theoretical fair values.

Stock market options give option holders rights to buy or sell shares at a certain price. Uniquely, options have expiration dates that put a time limit on those rights. The fair value of an option is the mathematical calculation of the value of those rights based on price volatility and the time remaining on the clock. Due to Wall Street savvy and software, the current market price of an option is a close approximation of the fair value. The market price -- as stand-in for fair value -- of an option can be divided into intrinsic value and time premium.

Look up the current details and price information on a trading stock option. The important facts are the type of option -- put or call -- the strike price and the current share price of the underlying stock. The expiration date is built into the option price and so is not relevant for this exercise. The strike price of an option is the stock price at which an option holder will buy -- for call options -- or sell -- for puts -- if the option is exercised.

Determine the "moneyness" of the option contract. "Moneyness" entails an option's intrinsic value. The more correct term for an option with intrinsic value is "in the money." A call option is in the money if the stock price is above the option strike price. A put option is in the money if the stock is below the put's strike price. If the option is out of the money, the entire price or premium of the option is time premium, and there is no intrinsic value.

Calculate the amount of intrinsic value of a call option by subtracting the option strike price from the current stock price. For example, the current stock price is $50 and the call option has a strike price of $45. This option is in the money by $5 -- which is the intrinsic value of the option. If the current market price of the option is $6, the remaining dollar of option value is the time premium.

Calculate the intrinsic value of a put option by subtracting the current share price from the option strike price. On the $50 stock, a put option with a $55 strike price is $5 in the money. The remainder of the cost of the put option is the time premium.

Tips

  • The intrinsic value of the option is the amount of money you would make by exercising the option and simultaneously selling -- call options -- or buying -- put options -- the underlying stock. If you own a call option that is $5 in the money, you can exercise the option and sell the shares to leave $5 per share in your brokerage account.
  • The time premium portion of an option's value is the worth of the rights given to the option buyer by the terms of the contract.
  • If the stock price is equal to an option's strike price, the option is said to be "at the money" -- neither in or out of the money. At-the-money options have no intrinsic value.
  • The fair value calculation of an option comes from a mathematical model that uses historical data to project a future value.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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