Meaning of Intrinsic Value of an Option
The intrinsic value of an option is the difference between the price of the underlying asset in the market and the exercise price.
Intrinsic value is always positive. When the difference between the price of the underlying asset and the strike price is negative, the intrinsic value equals 0. At expiration, the intrinsic value is the value of the option.
We must bear in mind that the price of an option has two components: the intrinsic value and the extrinsic value or time value.
Premium = Intrinsic Value + Time Value
Formulation of the Intrinsic Value of an Option
The formulation of the intrinsic value of an option is as follows:
- Intrinsic value of a call = Price of the underlying – Strike price
- Intrinsic value of a put = Strike price – Underlying price
Examples of Calculating the Intrinsic Value of an Option
Let’s imagine a call option on Gas Natural with strike 12 and a hypothesis of the spot (stock) price of 11, 12 and 13. The intrinsic value of the option is as follows:
We consider a put option on Gas Natural with strike 12 and a hypothesis of cash share prices of 11, 12 and 13. The intrinsic value of the option is as follows:
The graphical representation of the intrinsic value of a call option will be constant until it reaches the strike price, at which point it will begin to slope upward. In contrast, the graphical representation of a put option will be negative until it reaches the strike price, after which the slope will be constant.
In conclusion, we can say that the intrinsic value of an option has a negative relationship with the extrinsic value and a positive relationship with the premium. The price of the premium is influenced by the following factors:
- Underlying Asset.
- Exercise price.
- Interest rate.
- Time to expiration.