The Hindu Business Line : Call-Intrinsic and Time value

The premium that you pay to purchase a call can be broken down into two parts. One is the `intrinsic value' and the other is the `time value'.

Intrinsic value is simply what you would realise if the option were about to expire immediately. An option's market value will generally exceed its intrinsic value by an amount that is called the option's time value.

Let's examine this with an example. You have a June call option on Satyam with a strike on 160. If the current Satyam spot was trading at Rs 146, would you be willing to give this call for free? No. It is because the contract does not have intrinsic value as of now. However, it has time value that there is always a chance for the call to gain value over the three-month trading period.

At, In and Out: A call is said to be at-the-money (ATM) if the underlying value currently equals the strike price. Otherwise, the option is said to be in-the-money (ITM) if it has positive intrinsic value that is the underlying value is more than the strike price. The call is out-of-the-money (OTM) if it has zero intrinsic value (the underlying value is less than the strike price)

Intrinsic value of a call = underlying value- strike price

In the above example (Satyam), the call has zero intrinsic value (146-160) and hence is out-of-the-money. Therefore, the premium charged for purchasing the call reflects only its `time value'.

In the case of another June call with a strike of 130, the two components can be identified as follows. The call is in-the-money as the spot price is Rs 146. If the 130 Satyam Call is traded at Rs 30, Rs 16 (146-130) is intrinsic value and Rs 14 is the time value.

The easiest way to understand how this works is by the way of a payoff chart, which is a graphical description of what your profit/loss will be at different price levels showing whether you are in, at or out of the money.

* The loss for the call holder is limited to Rs 30, which is the premium paid.

* Whereas, if the spot price is anywhere above 130, you are in-the-money. Theoretically, going by the intrinsic value, you stand to gain if the spot is above 130-strike.

* Practically speaking, you factor in the premium paid, so that you break even only when the spot price is at 160-strike.

* Thus, any spot value above 160 will leave you with profits.

What is deep-in/out-of-the-money?

When the intrinsic value is very substantial, then the call option is said to be `deep-in-the-money'. Alternatively, it can also be said that the call is so far in-the-money that it is unlikely to turn out-of-the-money before the expiry date.

When a strike is so far than the spot that it is unlikely for the spot to move higher and turn the call in-the-money, then the call can be termed as `deep-out-of-the-money'.

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.