Editor’s Note: Today, I tackle intrinsic value, a concept that sounds sophisticated enough to impress your in-laws but is actually quite straightforward, once you unlearn everything Wall Street has ever tried to overcomplicate.

Simply put, intrinsic value is what an option is actually worth, beyond the hype, hope, and pure adrenaline that often fuel the options market. It’s the financial equivalent of asking, “Would anyone actually pay for this, or am I just betting on vibes?”

In the following article, I’ll cut through the noise and get to the core of what makes an option truly valuable. It helps to know when you’re holding something with real worth versus something destined for the trading graveyard.

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Pricing Options

Before you understand intrinsic value, you should first understand the concept of an option’s premium.

Simply put: an option’s premium is the price it’s offered on the open market. If you buy a call option for $20, then the option’s premium is $20.

That’s pretty straightforward. But why did traders determine that the option is worth $20?

There are three factors that contribute to an option’s premium:

• Implied volatility
• Time value
• Intrinsic value

Implied volatility is covered in detail in another guide.

Simply put: the higher the intrinsic value, the more expensive the option. Time value is the amount of money that traders are willing to pay to wait for an option to increase in value prior to expiration.

Intrinsic value, as we’ve seen, is the difference between the option’s strike price and the market value of the underlying security.

The formula for an option’s premium is as follows:

Implied volatility + Time value + Intrinsic value = Option premium

Intrinsic Value: Digging Deeper

There’s a little bit more to intrinsic value than the headline definition you read above. For starters, the calculation for intrinsic value is different between call options and put options.

Here’s how it works: for call options the intrinsic value is calculated by subtracting the strike price from the price of the underlying security. For put options the intrinsic value is calculated by subtracting the price of the underlying security from the strike price.

Why is it exactly the opposite for the two different types of options? It’s because of how we define “in-the-money.”

Remember: a call option is in-the-money when its strike price is lower than the current price of the underlying security. A put option, on the other hand, is in-the-money when its strike price is higher than the current price of the underlying security.

If you have a call option with a $70 strike price and the underlying stock is currently trading at $90, the intrinsic value is $20 ($90 – $70 = $20).

If you have a put option with a $30 strike price and the underlying stock is currently trading at $20, then the intrinsic value is $10 ($30 – $20 = $10).

Out-of-the-Money Options

How do you calculate the intrinsic value for out-of-the-money options? That’s easy: it’s $0.

The intrinsic value of an option can never go below $0. Do the math based on the formulas explained above and you’ll find that all at-the-money and out-of-the-money options have an intrinsic value of $0.

Why is that the case? Because a buyer of an option would never exercise an option that would result in a loss. Instead, the buyer would just let the option expire worthless.

In-the-Money: Why Does It Matter?

You might be wondering at this point why traders would care about the in-the-money portion of an option’s premium. To answer that question, let’s look at the basic nature of options.

Remember: people buy options for the right to buy or sell an underlying security at a specific price on a specific date. That’s why options exist.

But they’ll only exercise their right to buy or sell the underlying security if the option goes in-the-money. Otherwise, they can find a better deal on the open market.

Enter intrinsic value. It tells the trader how much payoff he or she can expect if the option expired immediately.

Hypothetical example: let’s say that you purchased a $100 call option for XYZ Corp. a month ago. Today, XYZ is trading at $102 per share.

If your option expires today, that means you could buy 100 shares of XYZ at $100 each, then turn around and sell them on the open market for $102 each. Your profit in that case is $2 per share ($102 – $100 = $2).

That $2 profit is also the intrinsic value.

Keep in mind: a positive intrinsic value doesn’t mean that your overall trade is profitable. If you paid $3 for that XYZ call option, then you effectively paid $103 per share for XYZ. If you claim the shares at expiration and sell them for the market value of $102 each, you’ll lose $1 per share on the overall trade.

Even though you can earn a profit on the stock trade with a positive intrinsic value, that doesn’t mean your overall option trade is profitable.

Intrinsic Value and Time to Expiration

Does the time to expiration influence the intrinsic value?

Nope.

Unlike some of the other metrics you’ll evaluate when you consider trading an option, time to expiration has absolutely no influence on the intrinsic value.

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Intrinsic value is the difference between the strike price and the price of the underlying security. Nothing more.

However, the time to expiration does influence the time value.

Time Value

If an option expires in 90 days, the underlying stock has plenty of time to rise or fall. Traders are willing to pay a little extra in hopes that it moves in their direction.

That “little extra” is called the time value of the option.

For example, let’s say XYZ is currently trading at $102 per share. You think it’s poised to pop over the next 90 days, so you check the options chains.

You find that the $105 call option that expires in 90 days is currently trading at $2.50. If you purchased that call option and the option went in-the-money at expiration, that means you’d effectively buy shares of XYZ at $107.50 per share.

Why? Because you’d buy the shares of XYZ at expiration for $105 each. But you paid a premium of $2.50 per share when you bought the option. That means your total investment is $105 + $2.50 or $107.50 per share.

Since XYZ was out-of-the-money when you purchased the call option, its intrinsic value was $0. That means part of your premium was derived from the time value of the option. The other part, of course, was derived from implied volatility.

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Jim Fink is the chief investment strategist of several premium trading services, including Velocity Trader, Options for Income, and Jim Fink’s Inner Circle.