What is Intrinsic value and Time Value of Financial Options?, In The Money, At The Money, Out Of The Money
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The price of an option is made up of a combination of intrinsic value and time value.
The intrinsic value of an option is the value of exercising the option right now. If the price of the underlying stock is above a call option strike price, the option has a positive monetary value, and is referred to as being in-the-money. If the underlying stock is priced cheaper than the call option’s strike price, the call option is referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder simply allows the option to expire worthless. This is because a rational investor would choose to buy the underlying stock at market rather than exercise an out-of-the-money call option to buy the same stock at a higher-than-market price.
For the same reasons, a put option is in-the-money if it allows the purchase of the underlying at a market price below the strike price of the put option. A put option is out-of-the-money if the underlying’s spot price is higher than the strike price.
The time value of an option is the premium a rational investor would pay over its current exercise value (intrinsic value), based on the probability it will increase in value before expiry.
