Intrinsic Value

In options, intrinsic value is the amount by which a contract is in the money: what it would be worth if it were exercised immediately at the underlying's current price. FINRA's investor glossary states it directly: in relation to options, intrinsic value is "the value of an option if it were to expire immediately with the underlying stock at its current price. This is the amount by which an option is in-the-money."

One clarification first, because the same two words name a completely different idea. In company analysis, "intrinsic value" means an analyst's own estimate of what a business is worth based on its financials and prospects, compared against the market price to judge whether a stock is cheap or dear. That is a judgment produced by a valuation method. The options sense on this page is not a judgment at all: it is an arithmetic fact about a contract's strike price and the current market price, and two people looking at the same option at the same moment will compute the same number. The valuation sense belongs to fundamental analysis; nothing below is about it.

The regulatory wording is worth seeing once, because it makes the mechanical character of the figure obvious. Appendix A to the SEC's broker-dealer net capital rule, 17 CFR 240.15c3-1a(b)(2)(i)(A), defines "intrinsic value or in-the-money amount" as "the amount by which the exercise value, in the case of a call, is less than the current market value of the underlying instrument, and, in the case of a put, is greater than the current market value of the underlying instrument". Two directions, one subtraction each.

The calculation, in both directions. A call gives the right to buy at the strike, so it is worth exercising when the strike is below the market price, and its intrinsic value is the stock price minus the strike. A put gives the right to sell at the strike, so it is worth exercising when the strike is above the market price, and its intrinsic value is the strike minus the stock price. In both cases the figure is per share, and a standard equity option contract represents 100 shares, so the per-contract amount is 100 times the per-share figure.

The floor at zero is a definition, not a convention. If the subtraction produces a negative number, the option is out of the money and its intrinsic value is zero. It is never negative, because nobody is obliged to exercise an option that would lose money to exercise, and the right not to act has no negative worth. FINRA's own entry for out-of-the-money says such a contract has "no intrinsic value". A reader who computes a negative figure has discovered how far out of the money the contract is, which is a real and useful number, but it is not the contract's intrinsic value.

Where the rest of the premium comes from. An option's market price is almost always more than its intrinsic value, and the difference is the second component, called time value in FINRA's materials and extrinsic value on this site. The same net capital rule that defines intrinsic value defines it directly: "The term time value shall mean the current market value of an option contract that is in excess of its intrinsic value." So the whole premium decomposes into exactly two parts, and the split explains the behavior readers find puzzling. An out-of-the-money option has zero intrinsic value, so its entire price is the second component, which decays to nothing by expiration. A deep in-the-money option is mostly intrinsic value, so it moves nearly dollar for dollar with the stock.

Why the SEC's list of premium determinants matters here. The SEC's own investor bulletin says a premium's amount depends on "the underlying stock price in relation to the strike price", "the length of time until the option contract expires", and the price volatility of the underlying stock. Only the first of those three produces intrinsic value. The other two produce the second component, which is why an option can be worth a great deal while having no intrinsic value at all.

Intrinsic value is not profit, and conflating them is the commonest error. The figure says what exercising would be worth today; it says nothing about what the holder paid to be in the position. A call bought for $6.00 a share that now trades at $4.60, of which $4.00 is intrinsic value, is down $1.40 a share even though the contract is in the money and worth exercising rather than abandoning. Note which two numbers that subtraction uses: the price paid and the price now, not the intrinsic value. The two questions, "is this worth exercising?" and "did this trade make money?", have different answers and need different arithmetic.

A small consequence for holders near expiration. Because the second component shrinks toward zero as expiration approaches, an option's price converges on its intrinsic value, and at expiration the two are the same thing. That is the sense in which intrinsic value is the floor an option's price approaches rather than the price it currently trades at.

Start with a call in the money. The stock trades at $103 and the contract has a $95 strike. Exercising immediately would mean buying at $95 something worth $103, so the intrinsic value is $103 − $95 = $8.00 a share, or 100 × $8.00 = $800 for one contract.

Consider an example of what that leaves. Suppose the same call trades at $11.50 a share, or $1,150 a contract. The extrinsic value is the remainder: $11.50 − $8.00 = $3.50 a share, or $1,150 − $800 = $350 a contract. A buyer paying $1,150 is paying $800 for value that exists today and $350 for the chance that the stock climbs further before expiration.

Now a put. The stock trades at $26 and the contract has a $30 strike. The right to sell at $30 something worth $26 is worth $30 − $26 = $4.00 a share, or $400 a contract. If the put trades at $5.20 a share, the extrinsic value is $5.20 − $4.00 = $1.20 a share, or $520 − $400 = $120 a contract.

Finally the out-of-the-money case, which is where the floor does its work. Take the same $95 call with the stock at $88. The subtraction gives $88 − $95 = −$7.00, so the intrinsic value is zero, not negative seven. If that call still trades at $0.45 a share, every cent of the $45 per contract is extrinsic value, and unless the stock climbs above $95 before expiration, all of it goes to zero.

One last check on what these numbers do and do not say. If the buyer of the in-the-money call paid $13.00 a share for it and the price is now $11.50, the position has lost $1.50 a share despite $8.00 of intrinsic value. Intrinsic value answers whether exercising is worth anything; it is silent about whether the trade was a good one.

Pros

• It is objective. Two people with the same strike and the same market price compute the same figure, with no assumptions or forecasts involved.
• Splitting the premium into intrinsic and extrinsic value explains at a glance how much of an option's price is already earned and how much is a bet on time.
• It is the fastest test of whether exercising is worth anything at all.
• Because it is the amount that survives to expiration, it shows what a contract converges on if nothing else changes.

Cons

• It is easily mistaken for profit, since it ignores the premium the holder paid to acquire the position.
• The same two words name an unrelated business-valuation concept, and mixing the senses produces sentences that are confidently wrong.
• On its own it says nothing about whether an option is expensively priced, which is a question about the other component.
• A figure that is exactly zero can look like an error to a reader who computed a negative number and expected to see it.