Tuesday, January 25, 2011

Intrinsic Value, Time Value & Volatility

Intrinsic and Time value:

The option price, or premium, can be considered as the sum of two specific elements:
- Intrinsic Value
- Time Value

Intrinsic Value:
The intrinsic value of an option is the amount an option holder can realize by exercising the option immediately. Intrinsic value is always positive or zero. An out-of-the-money option has zero intrinsic value.
Intrinsic value of in-the-money call option = underlying price - strike price
Intrinsic value of in-the-money put option = strike price - underlying price

Time Value:
The time value of an option is the value over and above the intrinsic value that the market places on the option. It can be considered as the value of the continuing exposure to the movement in the underlying product price that the option provides. The price that the market puts on this time value depends on a number of factors: time to expiry, volatility of the underlying product price, risk free interest rates and expected dividends.

Time to Expiry:
Time has value, since the longer the option has to go until expiry, the more opportunity there is for the underlying price to move to a level such that the option becomes in-the-money. Generally, the longer the time to expiry, the higher is the option’s time value. As expiry approaches, the value of an option tends to zero, and the rate of time value decay accelerates.

Time value decay curve


The volatility of an option is a measure of the probability of the price movements of the underlying instrument. Volatility is normally expressed in annualized terms. The more volatile the underlying instrument, the greater the time value of the option will be. Volatility does not measure the direction of price change. This means that greater the uncertainty for an option seller higher is the premium he will charge to be compensated. Thus option prices increase as volatility rises and decrease as volatility falls.

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