Intrinsic Value & Time Value of Options
Value of an Option
Generally the option premium is considered as the value of an option because it is the price at which an option can be bought or sold.
Value of an option is divided into the following two:
1. Intrinsic Value
2. Time Value
Intrinsic value of an option indicates the amount by which an option is in the money. For e.g. Exercise price of a call option is ` 60 and the prevailing market price is ` 63.
This call option is definitely exercisable from the view point of the option holder, who is in the position of “In the Money” by a gross pay off of ` 3. In such case the intrinsic value of the option is ` 3. In other words intrinsic value of an option is the gross pay off by which the holder is benefited on exercising the option.
Time Value = Option Premium – Intrinsic Value
It should be noted that generally the intrinsic value will never exceed the amount of option premium. In other words option premium will always be more than or equal to the intrinsic value. Therefore, time value will either be positive or zero.
However, in exceptional cases if the intrinsic value exceeds the option premium then by calculation, the time value will be negative, which should not be. In such exceptional cases the time value should be considered as zero.
Spread strategies are classified into following:
1. Bull Spread
2. Bear Spread
3. Butterfly Spread
A Bull Spread can be created by use of either call options or put options. A Bull Spread created using call options is known as “Bull Call Spread” or “Bull Spread with Calls”. Similarly, a Bull Spread created using put options is known as “Bull Put Spread” or “Bull Spread with Puts”. A Bull Spread will always result into a position where the investor who creates Bull Spread will make profits (Limited Profits) when the market price rises and will incur loss (Limited Loss) when the market price falls.
A Bear Spread can be created by use of either call options or put options. A Bear Spread created using call options is known as “Bear Call Spread”. Similarly, a Bear Spread created using put options is known as “Bull Put Spread”. A Bear Spread will always result into a situation where the investor who creates Bear Spread will make profits (Limited Profits) when the market price falls and will incur loss (Limited Loss) when the market price rises.
A Bear Spread or a Bull Spread is the simplest form of spread which can be created by simultaneously holding as well as writing call options or put options at same exercise dates but with different exercise price.
A Butterfly Spread can be created by use of either call options or put options. For creating a Butterfly Spread, identify three options with exercise price as E1, E2 and E3, such that (E2 – E1) = (E3 – E2) and E2 should be at around current market price.
For creating a Long Butterfly using call options, the investor should buy 1 call each at Exercise Price of E1 and E3 respectively & sell 2 calls at Exercise Price of E2 each.
For creating a Short Butterfly using call options, the investor should write 1 call each at Exercise Price of E1 and E3 respectively & buy 2 calls at Exercise Price of E2 each.
A Condor is an extended version of Butterfly Spread and can be created by use of either call options or put options. For creating a Condor, there must be four call options or four put options at different exercise prices as E1, E2, E3 and E4
February 02, 2021
February 02, 2020
April 04, 2019
Congratulations…!! CA Harish Wadhwani for scoring 93 marks in SFM (CA Final)
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