This is the second part of the article about calculating intrinsic and time value of options. Here you can read the first part: Call Option Price, Intrinsic, and Time Value.
In the money put option example
Now consider a put option (giving the owner a right to sell) on J.P. Morgan stock, expiring in December 2009. Its strike price is 47 and its market price is 4.60 dollars. J.P. Morgan stock is trading at 44.50.
What is the intrinsic value? The idea is the same as with call options, but now when we exercise the put we are selling the underlying, so we want to sell as high as possible. A put option’s intrinsic value is the amount by which the put’s strike price is higher than the current market price of the underlying stock. The strike is 47 in this case and J.P. Morgan stock is trading at 44.50. Therefore the intrinsic value is 47 less 44.50, equal to 2.50 dollars.
Time value is again what is left from the option’s market price after subtracting intrinsic value. 4.60 less 2.50 are 2.10.
Out of the money put option example
In our last example, we now have another J.P. Morgan December 2009 put, this time with the strike price of 42. Its market price is 2.25.
What is the intrinsic value? Strike (42) is below the underlying stock’s market price (44.50) and we would not save money by exercising the option. Therefore the option is out of the money and has zero intrinsic value. As a result, the whole market price of the option is equal to the time value (2.25).
All calculations have the same logic
You see that the logic is the same in all four cases and you can summarize the calculation in 2 easy steps:
- Compare strike price with market price of the underlying stock (get intrinsic value)
- Subtract the intrinsic value from the option’s market price (get time value)
Only two things vary across the four examples. Firstly, there is the difference in the direction (what you subtract from what when you calculate the intrinsic value) between calls and puts. Remember that with calls you are buying the underlying (want low price), while with puts you are selling it (want high price).
Secondly, there is the fact that out of the money options always have the intrinsic value of zero, therefore at the moment you figure out that an option is out of the money, you can tell that its time value is equal to its market price.
What about at the money options?
Now you might be wondering why we have not been talking about at the money options in this article. When an option is exactly at the money, its strike price is equal to the current market price of the underlying. Regardless if it is a call or a put, the intrinsic value is always zero in this case. As a result, the option’s time value is equal to its market price, exactly the same as with out of the money options.
Final note about contract sizes of stock options
Throughout the two articles we have been using the examples of J.P. Morgan stock. Note that options on individual stocks traded in the US trade in contracts which have a size of 100 shares of stock. They are however quoted on the per share basis. Therefore, when we said an option’s market price was 4.60 dollars, in reality you would be buying the option for 460 dollars and its underlying asset would be 100 shares in J.P. Morgan Chase. Similarly, when we calculated a time value of 2.10, the real dollar amount would be 210 etc.