Time is Money: How to Find Value in Options

Time Value and Intrinsic Value

Understanding the value underpinning stock options

James DiGeorgia

Even if you’re a conservative stock investor, you can use several very conservative option strategies to maximize your stock returns.

This week I’m continuing our options education series by explaining options premiums. You will see how the old saying "time is money" is literally true.

Let’s start with the definition for "options premium." It is best broken down into component parts: time value and intrinsic value.

It is important to know how to break an option’s price into these two components as well as understand the interpretation if you want to maximize your returns.

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In-the-money vs. out-of-the-money

Before you can break an option’s premium into time and intrinsic values, you need to understand the terms "in-the-money" and "out-of-the-money," also called the moneyness of an option.

It starts with identifying the current price of the stock.

An option is in-the-money when the stock price is higher than the strike for calls and lower than the strike for puts. If a stock is trading for $100, a $90 call is in-the-money and a $90 put is out-of-the-money.

The following chart may help:

An option that is exactly at the strike price is said to be at-the-money.

Now, it’s rare to find a stock trading exactly at the strike price, so it is customary to call the nearest strike (whether in- or out-of-the-money) the "at-the-money" strike.

For example, if a stock were trading at $99.50, most traders would consider the $100 strike at-the-money even though the strike is slightly out-of-the-money.

Likewise, if the stock were slightly higher, say $100.25, most would call the $100 strike "at-the-money" even though it is slightly in-the-money.

In-the-Money: How to Arrive at Intrinsic Value

If an option is in-the-money, it is said to have intrinsic value. This is the value of the option if you were to exercise it immediately — the difference between the stock price and the strike.

For example, if the stock is trading for $101 and you hold the $100 call, you could realize a $1 gain by exercising the call option; you would receive stock worth $101, but pay only $100*.

* With most options, you can exit a position at any time, but generally individuals don’t "exercise" their options early.

Another way to view intrinsic value is to calculate the value of the option if it were to expire immediately.

Using the above example, if the $100 call option expired, it would be worth $1, the same value as if you exercised early.

Why will it be worth $1? If it is trading for less than that, say 50 cents, arbitrageurs will correct for it by buying the option for 50 cents and selling the stock for $101, for a net credit of $100.50.

Further Reading for

Investors Who Use Optons

To catch up on past articles in our options education series, click on the links below.

What’s the Best Options Strategy?

Covered Calls: The Short Road to Long-Term Stock Gains

Selling Puts: Get Paid a Dowry Before Committing to an Equity

Why Options (and Options Traders) are Good for the Market

By immediately exercising, they can cover the short position by paying only $100, the strike, for an arbitrage profit of 50 cents. This would continue until the option is priced at a minimum of $1.

For puts, the idea of intrinsic value is the same but in the other direction. If the stock were trading for $99, the $100 put would have an intrinsic value of $1. The holder of the put could exercise and sell stock worth $99 but receive $100 — a $1 gain.

Also, if the put option expired immediately, it would be worth $1. If it is worth less than this, say $0.50, arbitrageurs will buy the put for $0.50 and buy the stock for $99, for a total purchase price of $99.50.

Then they would immediately exercise it, sell the stock for $100, and capture a 50-cent arbitrage profit. This would continue until the option is priced at a minimum of $1.

Probably the easiest way to understand intrinsic value is to think of it as the number of points (dollars) the stock is in your favor in relation to the strike price.

For example, if you are long a call, you are bullish and want the stock to go up. If you have the $100-strike call with the stock at $103, then your option is 3 points in-the-money; the stock is trading $3 points to the bullish side (above) of your option.

If you are long the $105 put, you are bearish and want the stock to fall. With the stock at $103, the stock is two points to the bearish side of (i.e., below) your strike.

Time Value

Time value (or time premium) is easy to calculate. It’s what is left over after accounting for intrinsic value. Assume a $100 call is trading for a premium of $3.

If the stock is trading for $101 then the $100 call has intrinsic value of $1; the remaining $2 is called time premium. The following formula may help:

Premium – intrinsic value = time value

What if the stock were trading at $100? Now, the $100 call is at-the-money and has no intrinsic value.

With the option trading for $3, the entire premium is all time premium.

This would be true for any stock price at or below $100; the option would be comprised entirely of time premium.

For puts, let’s assume the stock is $98 and you are holding the $100 put, which is trading for $5. The option has $2 intrinsic value and therefore has $3 time value.

Examples:

How much time premium do options have?

Generally, there will always be some time premium on an option, even if only a small amount.

With all else constant, the longer the maturity of the option — or the more-volatile the underlying stock — the more you will pay in time premium.

Why? With all else constant, investors will prefer to buy longer-term options, as they will have more time for it to gain intrinsic value.

Likewise, investors will prefer more-volatile options because they have a greater chance of making bigger moves. That would give the option more intrinsic value.

Also, the deeper-in-the-money you go, the more time premium will decrease. So if the stock is $100, the $80 call will have less time premium than the $85 call, and the $85 will have less than the $90, etc.

If the option is deep enough in-the-money, the time premium will equal the risk-free rate. Why?

If the stock is at $100 and the $80 call is sufficiently in-the-money, investors can buy the stock and sell the $80 call (covered call strategy) — thereby "guaranteeing" them $80 at expiration. As with any guaranteed trade, the interest rate will be the risk-free rate.

Now, I should mention that a covered call is never truly guaranteed, as it is always possible for the stock to fall below the strike price of the short call.

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However, if it is sufficiently deep-in-the-money where the markets perceive it is guaranteed, then the market will only reward you the risk-free rate for that trade.

The important point to understand is that, as you move to lower and lower strikes for calls (or higher strikes for puts), they become more and more likely to have intrinsic value.

Because of this, they will have correspondingly lower amounts of time premium.

Parity

If there is no time premium on an option, it is said to be trading at parity. For example, with the stock at $103, a $100 call trading for $3 would be trading at parity; there is no time premium on this option.

Usually, the only time you see an option trading at parity is at expiration with options that are fairly deep-in-the-money.

How do you use this information to trade?

I said earlier that it is important to understand time value and intrinsic value in order to know what you’re getting into with a particular option.

Any option that has high time premium is risky (in trading terms, it will have a high gamma value).

The reason it is risky is that the underlying stock must move enough in the proper direction to make up for the time premium. If it doesn’t, you will end up with a losing trade.

For example:

  • If you buy a $100 call option for $10 with the stock at $100, the stock must get to $110 (stock price plus time premium) in order to break even.
  • If the stock moves to $108 at expiration, the $100 call will be worth $8, yet you paid $10 for a $2 loss.

Now compare this to the trader who may have purchased the $80 call, which may have been trading for $21 ($20 intrinsic + $1 time premium).

With the stock at $110 at expiration, the $80 call will be worth $30.

This trader bought for $21 and sold for $30 — a profit of $9, which is certainly different from the $2 loss taken with the $100 call

If you are looking for very quick moves in the underlying, you can afford to buy options with higher time premium.

However, if you are only interested in speculating on the direction of the underlying stock, you should consider deeper-in-the-money options to avoid the high risk associated with high-time-premium options.

But avoiding the speed game is not free.

If you buy a deep-in-the-money option, you will pay more in total dollars (more intrinsic value and less time value). You will have more money at risk if the stock moves against you.

In addition, if the stock should fall, the deep-in-the-money option will fall nearly point-for-point through a certain range of stock prices before slowing.

Finding the right options for your needs is a delicate balancing act.

Option trading mistakes

One of the biggest mistakes new option traders make is to buy an option just because it is "cheap." Inexperienced traders often look to out-of-the-money options because they can buy more contracts for a fixed dollar investment.

For example, if a stock is trading at $50, a new trader who is bullish on the stock will usually look at a $55 strike or higher.

They often wonder why one should buy an in-the-money option, as the stock has already exceeded the strike price. They feel they are "wasting" money by paying for the intrinsic value.

Here’s the point they’re missing …

Cheap options are usually composed entirely of time premium and can be far-out-of-the-money. Make sure you know where your breakeven point is and that it matches your sentiment with the underlying.

For example, if the stock is $100 and you want to buy the $115 option for $2, the stock will have to move to $117 by expiration in order to break even on the trade.

If you do not think this is likely, you should probably consider another option.

A deeper-in-the-money option will be more-costly but have less time premium; it will not need to move as far to break even.

Many, even the most conservative, options strategies rely on the behavior of time premium. And that’s the reason a solid understanding of time and intrinsic values is so important.

Best wishes,

James DiGeorgia

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