Call options are contracts that allow you to purchase shares of stock at a guaranteed “strike price” until the expiration date stated in the contract. The cost of the call option is called the premium and is made up of two parts: the intrinsic value and the time value. Understanding intrinsic value and time value is essential because these two values tell you when you can exercise the call option profitably. "Exercising" an option refers to using it to buy the underlying stock.
When the strike price of a call option is lower than the market price, the option is said to be “in the money" because only then can you make money by exercising your right to buy the shares. Call options work this way because you pay the strike price to buy the shares. Exercising the option has a potential for profit only if you can sell the shares for more than you pay for them, so the market price needs to be higher than the strike price. When the market price is less than the strike price, the option is out of the money. Exercising an option that is out of the money is worse than useless, because you would pay more for the shares than they would cost if you bought them at the market price.
Calculating Intrinsic Value
The intrinsic value of a call option is the difference between the strike price and the market price when the option is in the money. If the option is out of the money, the intrinsic value is zero. In other words, intrinsic value tells you how much money you keep if you exercise the option to buy the shares and sell them at the current market price. Suppose you purchased a call option with a strike price of $20 per share, and the current market price is $23 per share. Subtracting $20 from $23 leaves an intrinsic value of $3 per share.
The premium is always greater than zero until the call option expires, and is always more than the intrinsic value. If you subtract the intrinsic value from the premium, the difference is the time value of the call option. Time value starts when the option contract is first sold as the amount the option seller, also called the option writer, charges to cover her costs. This component of a call option premium is called time value because it gets smaller as the call option gets closer to its expiration date.
The fact that a call option is in the money does not automatically mean you will make a profit if you exercise the option. However, you can use intrinsic value to calculate your break-even point. Suppose you purchased a call option with a strike price of $20. You paid $4 per share for the option contract, of which $3 was intrinsic value and the remaining dollar was the time value. If you add the premium you paid to the strike price, you get $24. If the market price reaches $24 before the option expires, you can exercise the option and get all your money back. Now, subtract the strike price from $24. You get $4, which is the intrinsic value the call option must have for you to break even. Anything over an intrinsic value of $4 is profit.
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