A closer look at Option Premiums
The option premium (i.e. the price of the calls and puts that you see on your trading screen) has two components:
- Intrinsic value (IV), which is also known as parity value.
- Time value (TV), which is also called a premium over parity.
Premium=intrinsic value+ time value
- Intrinsic value is the amount by which the strike price of an option is in-the-money (if it is ITM). It can also be defined as the amount of money you would make if you were to exercise the option contract at that point in time.
The intrinsic value can either be positive (if you are ITM) or zero (if you are either ATM or OTM). An asset cannot have negative intrinsic value (in which case, the entire premium of such options consists of time value only)
Any option that has an intrinsic value is said to be ITM.
- The intrinsic value of a call option=spot price – strike price.
- The intrinsic value of a put option=strike price – spot price.
- Time value: is the portion of the premium, which is over and above the intrinsic value of an option (i.e. time value = premium – intrinsic value)
Time value basically puts a premium on the time left to exercise an option. This means that if the time left between the current date and the expiration of a given contract, A is longer than that of contract B, then Contract A has a higher time value. This is because contracts with longer expiration periods give the holder more flexibility on when to exercise their options. This longer time window lowers the risk for the contract holder and prevents them from landing in a tight spot.
An option is said to have time value if it is ATM or OTM (in other words, a call that is ATM or OTM has only time value). All other things being equal, an option is a depreciating asset. The option’s premium erodes daily and this is attributable to the passage of time. Usually, the max time value exists when the call (or put) is ATM (as the IV is zero when both strike price and the spot prices are the same).
The time value of
- Call option = call premium – intrinsic value
- Put option = put premium – intrinsic value
Nifty spot price (on September 14, 2020) = 11,440.05 points
Days to expiry = 9 days
