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Intrinsic Value of Options Explained

I nvesting in the stock market can be risky. Once you decide to take the plunge, there will be many learning curves for you to overcome. One of these learning curves is understanding the intrinsic value of options as it pertains to the stock market. Knowing what intrinsic value is and how to calculate it for options contracts could turn your investments into larger profits.

Key Takeaways

  • Intrinsic value is based on an investor’s perception of the value of an asset.
  • Options are contracts that allow investors to purchase or sell shares and stocks.
  • Intrinsic value helps investors understand the value of assets, including stocks and shares.
  • There’s no universal way to calculate intrinsic value. A financial analyst uses different factors to create an evaluation model to calculate intrinsic value.
  • Market value is the current value of a company based on its stock price.

What Is Intrinsic Value?

Intrinsic value is the investor’s perception of an asset’s value, whether that asset is a company, stock, option, or real estate. This value is an objective calculation rather than the current trading market price. When referring to the intrinsic value of an option, it means the difference between the strike price of the option and the current price of the underlying asset.

In layman’s terms, intrinsic value is how much an option would be worth if it expired right now. A financial analyst uses technical and fundamental analysis to estimate an asset’s intrinsic value. They will look at different aspects of a company, including quantitative, qualitative, and perceptual factors, to calculate this value.

Image via Flickr by free pictures of money

What Is an Option?

An option is a contract that allows you to purchase or sell shares of stocks. These contracts are for a certain period of time, for a specific price, and usually are in bundles of 100 shares. An investor has the right to buy or sell their shares as an option, but they’re not obligated to fulfill the contract, thus leaving investors in more control.

There are two types of options. The first type is referred to as puts. A put is when the investor thinks the stock will fall. The other option is called calls. Calls refer to when the investor believes the stock will rise.

Benefits of Intrinsic Value Options

There are benefits to understanding the intrinsic value of options. The intrinsic value of options helps an investor understand the cost of an asset. Investors can determine if an investment is undervalued or overvalued when compared to the market value. When entering an options contract, investors have the control to execute the order or to let it expire.

If the option has no intrinsic value, the buyer won’t execute the option, or they would let it expire. This results in no payoff as the buyer would not want to take a loss. Once you’re more versed in the stock market, this could be a way to increase your investments if you own 100 shares of a company.

Calculating Intrinsic Value

So, how is the intrinsic value calculated? There’s no universal method. Instead, a financial analyst looks at different factors of a company to build a valuation model. They will base their valuation on qualitative factors, including what a company does regarding governance, its business model, and target markets. They will also look at quantitative factors, such as how well the business is performing as well as the company’s financial ratios and financial statement analysis.

Finally, the financial analyst observes the perceptual factors, which are investors’ perceptions of the relative worth of the asset. The financial analyst then uses a mathematical model to weigh these factors.

The financial analyst determines if the investment is overvalued or undervalued when compared to the current market value.

An option has intrinsic value only if it’s ‘in the money.’ To be in the money, an option must have a positive payoff for the buyer. For in-the-money call options, you would take the price of the underlying asset minus the strike price, which will give you the intrinsic value. For in-the-money put options, take the strike price minus the price of the underlying asset to get the intrinsic value.

Real-World Examples

Let’s take a look at call options. A call option is when an investor predicts the stock will rise. A call option is put in place for a strike price of $20. The current market price of the said stock is going for $30. This means the intrinsic value would be $10. If you decide to execute this option, you would buy the option for $20, then sell it on the market for $30, resulting in a $10 profit. In reality, that would be a $1,000 profit as each option is sold in 100 shares.

Now let’s look at a put option example with a strike price of $40 for a stock. The actual market price is $35. This would give you an intrinsic value of $5 as you could potentially make a $5 profit. You would buy the option at $35 and exercise the option to sell it at $40. This would put you in the money with a potential profit of $500.

It’s also possible for an option to have no intrinsic value. In a call scenario, if the strike price is higher than the market price (for example, the strike price is $20 and the current market price $10), you wouldn’t execute this order, resulting in no intrinsic value. In a put option, the strike price would be lower than the current underlying price. This is called ‘out of the money.’ If the strike price is equal to that of the underlying security, it’s said to be ‘at the money.’ You wouldn’t want to execute either of these orders.

Intrinsic Value vs. Market Value

Intrinsic value and market value are both ways to value a company. However, there’s a considerable difference between them. Intrinsic value, as discussed previously, is an estimate of the actual real value of a company. Market value is the current value of a company as reflected by the stock market price. With that said, there could be a significant difference in price between the two. Market value is often referred to as the market capitalization of a publicly traded company. To figure out its worth, multiply the number of its outstanding shares by the current share price.

It can be exceedingly difficult to arrive at a company’s intrinsic value. However, it can be just as challenging to come up with the market value of a company. Market value will reflect supply and demand in the investing market. Another factor to consider is the value of illiquid assets. Due to this, it can be challenging to determine the true market value of a company.

It’s best to invest in a company with a higher true value than being given a value by the market. If there’s substantial investment demand, the market value tends to be higher than the intrinsic value. This can lead to overvaluation. If the investment demand is weak, this could result in the undervaluation of the company. Either of these situations can make it challenging to know when to enter into a contract for the intrinsic value of the option.

T he intrinsic value of an option is another way to enhance your investment options in the stock market. Understanding when a company might be making a move for the better or worse could result in an excellent intrinsic value of an options contract. Intrinsic value lets you have more power over your investments, which could result in larger returns. However, when using this option, it’s recommended that you’re well-versed in the stock market. The intrinsic value strategy isn’t one you want to jump into without knowing some of the ins and outs of the market.