What’s the in-the-money portion of an option’s premium? The answer to that question is its intrinsic value.

What that means is this: the intrinsic value of an option is the difference between its strike price and the current price of the underlying security.

That’s the high-level definition, anyway. There are some caveats.

In this guide, I’ll go over the concept of intrinsic value so you’ll know how to use it when you look for options that can give you a positive return.

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.

Read This Story: Implied Volatility With Options Explained (Simple 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.

So 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.

So if you have a call option with a $70 strike price and the underlying stock is currently trading at $90, then 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.

Read This Story: In the Money Options Explained (Simple Guide)

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.

Example: let’s say that you purchased a $100 call option for Walmart (NYSE: WMT) a month ago. Today, Walmart is trading at $102 per share.

If your option expires today, that means you could buy 100 shares of Walmart 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 Walmart call option, then you effectively paid $103 per share for Walmart. 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.

So 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.

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.

Read This Story: Time-Decay in Options Trading Explained (Simple Guide)

For example, let’s say Walmart 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 Walmart at $107.50 per share.

Why? Because you’d buy the shares of Walmart 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 Walmart 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.