Premium price is nothing but the options current market price value. Once again, not to be confused with strike price which is just the betted/predicted/expected figure to which the stock may reach in the near future. Premium price is made up of two values – Intrinsic value and time value.
Intrinsic Value + Time Value = premium (Option’s current market price)
Before reading about intrinsic value, we suggest you to go through our ‘Moneyness of Options‘ article. First thing we would like to bring to your notice is that, there will be intrinsic value only to ITM, In The Money Options. There will be no intrinsic value to Out The Money or At The Money options.
Intrinsic value is the difference between current stock value and strike price of particular option. If we take nifty as example, say nifty is trading at 5668 and we want to calculate strike price for 5600 CALL (ITM). The difference between current market price (5668) and strike price (5600) is 68. So the intrinsic value is 68. This is because the option call we took is IN THE MONEY option.
In the next example, take OUT THE MONEY Option call, say 5700 CE and current trading price as 5668. The formula remains same with the difference between current market value and strike price, 5668-5700 = -32 which is negative in nature. Even AT THE MONEY options leave a balance of Zero. To conclude, intrinsic value does not exit for Out The Money option calls.
For PUT option, formula stands totally reverse, Strike price – Current Trading value as we have read in our ‘Moneyness of options’ article that the IN THE PRICE Option calls are the one which above the current trading price.
FOR CALL/PUT option, INTRINSIC VALUE EXITS ONLY FOR ‘IN THE MONEY’ OPTIONS AND NOT FOR ‘OUT THE MONEY’ AND ‘AT THE MONEY’
Like intrinsic value, time value is not an easy calculation to perform. before, we first try to let you know what exactly is time value. In simple, its like an Ice cube which melts with the time. In the starting of the month, maximum time value exits and as time progresses, time value too comes down irrespective of market movement, up or down. It is nothing but just like the interest you get for bank deposits. A person who purchases an option at the start of the money gets a higher rate of interest and the one who purchases at the end of the month does not get anything as the time is zero. This rate of interest, ‘r’ exactly resides at the power in the formula. So, if the time value is zero at the end of the month, anything power zero is zero and so the time value also. In general, it is said that the option looses 1/3 it’s time value in the first half days and 2/3 in the second half of its expiry. The best way to calculate time value is ‘Premium-intrinsic’ value which is just the other way of our original formula.
TIME VALUE STARTS WITH MAXIMUM AND ENDS WITH ZERO IRRESPECTIVE OF MARKET VALUE, INTRINSIC VALUE AND STRIKE PRICE
So, if you buy Nifty 5600 CE when markets are at 5668 at a premium of 80, the intrinsic value is 68 and the remaining value (80-68=12) is the time value of the option at the particular period. Important point to note that if the markets remain there at 5668 till the end of the month, the premium becomes 68 with only intrinsic value as time value nullifies to zero.
In the next post, we explain you about the profit and loss calculation of options