The Options Basics Explainer introduced the concepts of call and put options, strike price, expiry, and long or short positions in an option contract. This page looks in more detail at option pricing.
In the money or out of the money?
An option is a derivative contract that derives its value from the underlying asset and gives the holder the right – but not obligation – to buy or sell the underlying asset at the pre-determined strike price at or before the contract expires. The relationship between the (forward) price of the underlying asset and the strike price determines the intrinsic value or ‘moneyness’ of the option. At a given point in time during the contract or when it expires, there are three possible scenarios:
- The option is in the money (ITM). A call option is ITM when the strike price is lower than the underlying asset’s current or forward price. In this case, the call option gives the holder the right to buy the underlying asset at a price lower than the current price, giving value to the option. A put option is ITM when the strike price is above the underlying asset’s current or forward price. An ITM put option gives the holder the right to sell the underlying asset at a price higher than the current price.
- The option is at the money (ATM). The underlying asset’s current or forward price and the strike price are the same.
- The option is out of the money (OTM). A call option is OTM when the underlying asset’s current or forward price is lower than the strike price. A put option is OTM when the underlying asset’s price is higher than the strike price. If an option is OTM at expiration, it expires with no intrinsic value. OTM options do have value prior to their expiry date, as explained below.
The price that the buyer of the option has to pay for the right granted by the option, i.e. the option premium, is the value market participants place on the option. This reflects the likelihood that the option will expire ITM. Also, the higher the likelihood, the higher the premium.
Components of the option premium
The option premium (P) consists of two components: the intrinsic value (I) and the time (extrinsic) value (X) or P = I + X. The intrinsic value is the option holder’s pay-off, if they were to exercise the option right now. The intrinsic value is calculated as the difference between the current or forward price of the underlying asset and the strike price of the option, as explained above. An ITM call option with a strike price of $20 on an underlying asset priced at $30 has an intrinsic value of $10. In contrast, ATM or OTM options have no intrinsic value.
The time value represents the additional amount investors are willing to pay for the likelihood that the option will increase in value between now and the expiration date. The longer the time to expiration, the more time there is for the option to increase in value. Also, the higher the volatility of the underlying asset, the more potential there is for large price fluctuations and the more likely it is that the option expires ITM. The time value is not as straightforward to calculate, as the intrinsic value and option traders use pricing models to determine the fair value and time value of the option contract. Time value can be deduced by looking at the option premium in the market and subtracting the intrinsic value, if any.
To summarize, the intrinsic and time value help investors understand the risk and rewards of options. The option premium of ITM options consists of both intrinsic and extrinsic value. In contrast, ATM or OTM options do not have any value if they are exercised immediately, so the premium on those options only consists of time value.