Value of an Option
When traders talk about the value of an option contract, they tend to use a common set of terms to describe the varying levels of an option contract. The terms they use are time until expiration, time value, intrinsic value, and moneyness.
Moneyness is a term to describe whether a contract is either “in the money”, “out of the money”, or “at the money”.
A call option is said to be “in the money” when the future contract price is above the strike price. A call option is “out of the money” when the future contract price is below the strike price.
DID YOU KNOW? – Approximately 20% of the total volume at CME Group is Options Volume. This is impressive given that options have been around only about 35 years while futures have a much longer history—150 years.
For a put option, the contract is said to be “in the money” when the future contract price is below the strike price, and “out of the money” when it is above the strike price. The term “at the money” refers to the strike that is closest to the underlying futures contract. When this happens both the call and the put option will be “at the money” at the same time.
The terms “in the money” and “out of the money” refer to the option contract itself and do not represent the profitability of your trade, nor does it depend on whether you have bought or written the option.
Time Value & Intrinsic Value
When an option is in the money it is said to have intrinsic value, and when the contract is out of the money it has no intrinsic value. When an option expires out of the money, traders will say that contract has “expired worthless”. Intrinsic value is the value of the option if it expired at this moment.
Up to this point we described the value of an option contract at the point of expiration, but what is the value of the contract before expiration?
The value of an option is comprised of two parts, the intrinsic value and the time value. When added together, they give you the “option value”.
Option Value = Intrinsic Value + Time Value
When an option contract expires, the time value would be zero. At this point the option value is equal to the intrinsic value.
Option Value = Intrinsic Value + 0
Let’s look at an example when the option has time value greater than zero. Suppose a call option will expire in one month. Here the option value will be higher than the intrinsic value. Even as the futures contract price moves around, the option value will still be greater than the intrinsic value, and that difference is the time value.
As time moves towards expiration, the time value shrinks or decays. The time value of an option (before its expiration date) will always be greatest when the option is at the money.
You can see the entire option value will always be greater than the intrinsic value until it reaches expiration.
There you have it, you now know how to use terms like moneyness, time value, and intrinsic value to express the value a put or call option.
Peter Knight Advisor