CFA Level 1 - Derivatives
Note that the above forms of moneyness do not take the cost of the option contract, or premium, into account.
- Payoff - Calculated by deducting the option premium paid from the intrinsic value of the option. In this case, an in-the-money option could produce a negative payoff if the premium is greater than the intrinsic value of the option.
- Intrinsic Value - Intrinsic value in options is the in-the-money portion of the option's premium. It is the value that any given option would have if it were exercised today. It is defined as the difference between the option's strike price (X) and the stock's actual current price (CP). In the case of a call option, you can calculate this intrinsic value by taking CP - X. If the result is greater than zero (in other words, if the stock's current price is greater than the option's strike price), then the amount left over after subtracting CP - X is the option's intrinsic value. If the strike price is greater than the current stock price, then the intrinsic value of the option is zero - it would not be worth anything if it were to be exercised today (please note that an option's intrinsic value can never be below zero). To determine the intrinsic value of a put option, simply reverse the calculation to X - CP.
- Time Value - The time value is any value of an option other than its intrinsic value. Time value is basically the risk premium that the seller requires to provide the option buyer with the right to buy or sell the stock up to the expiration date. While the actual calculation is complex, fundamentally, time value is related to a stock's beta or volatility. If the market does not expect the stock to move much (if it has a low beta), then the option's time value will be relatively low. Conversely, the option's time value will be high if the stock is expected to fluctuate significantly.
Time value decreases as an option gets closer and closer to expiration. This is why options are considered "wasting" assets. As an option approaches expiration, the underlying stock has less and less time to move in a favorable direction for the option buyer; therefore, if you have two identical options - one that expires in six months and one expires in 12 months - the option that expires in 12 months will have greater time value because it has a better chance of moving higher.