An Investor’s Guide to Understanding an Option’s Value

An option’s value is derived from two components: its intrinsic value and its time value. By adding these together, an investor may determine the option’s current worth.

The intrinsic value of an option is defined by its moneyness or where the current market value of the underlying asset is in relation to the option’s strike price. An option is either categorized as “in the money,” “out of the money,” or “at the money.”

Investors often purchase call options because they believe an asset’s price will likely appreciate looking ahead. Call options give a buyer the right — but not the obligation — to purchase the underlying asset at the strike price at or before expiry, according to the option’s contract. A call option is “in the money” when the underlying asset’s price rises above the strike price.

Investors generally purchase a put option because they maintain a bearish outlook on the asset’s price trajectory looking ahead. A put option gives the buyer the right (not obligation) to sell an underlying asset at a specified strike price at or before expiry, according to the option’s contract. A put option is “in the money” when the underlying asset’s price falls below the strike price.

An “out of the money” call option is one in which the underlying asset’s price is below the strike price. Likewise, an “out of the money” put option means the underlying asset’s price currently sits above the strike price. Meanwhile, an “at the money” option is one in which the underlying asset price is at the strike price.

In-the-money options have intrinsic value and generally cost more to purchase than out-of-the-money or at-the-money options. At the money and out of the money options have no intrinsic value. It’s important to remember, as well, that the moneyness of an option refers only to the option itself, not potential profit when traded.

When calculating an option’s current value, the time value makes up the other half of the equation. Understanding the role of time regarding options value may help investors make more informed decisions.

Determining an option’s value at expiry is fairly straightforward. As option value equals the intrinsic value plus the time value, at expiration, the time value is zero. This means that an option’s value at expiration is equal to its intrinsic value.

To calculate an option’s value before expiration, time must be taken into account. The greater the time until expiration, the more valuable the option. If an option expires in three months, the time value will be higher than if it expires in three weeks.

When calculating an option’s value before expiration, it’s important to remember that the overall value will always be higher than the intrinsic value, regardless of any price movement. This is because option value = intrinsic value + time value. As an option draws closer to its expiration, the time value decays or grows smaller.

Understanding the moneyness and role of time in determining an option’s value may help options investors make educated decisions for their portfolios. Considering not only the types of options used but also how a strategy invests in options according to moneyness and time allows for better potential alignment with an investor’s desired outcome when choosing an options strategy to invest in.

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This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.

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