What’s the value of your put options? In this episode, we explain the concept of intrinsic value as it applies to options, and then show examples of how to calculate it for put options specifically. Then, we walk you through a practice question from Achievable’s FINRA courses that may be similar to an actual FINRA test question on this topic.
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00:00:00 Puts intrinsic value in the money, out of the money. Let's talk about it. Intrinsic value, which is also known as in the money or exercise value, is the value the holder of the option, the long side receives when they exercise the option. And what we're doing is comparing the exercise value to the market value of the security. 00:00:23 Now, as I'm saying that that sounds a little confusing, but let's use some numbers to better understand this concept. A50 put has $4.00 of intrinsic value when the market price is 46. Now let's think a little bit about what A50 put is. A50 put is the right to sell at 50. Isn't there a right and an obligation? And there's two sides of the option. Yes, yes, yes. 00:00:49 Totally right. On a contractual basis, A50 put gives whoever owns that option or whoever is long or holds that option the right to sell stock at 50. So as a contract that's what it is right to sell. But whoever writes up that contract, whoever creates that contract is the side that has the obligation. So let's think about this for a second and we can even do a little role play. 00:01:14 Let's say that I write up a contract that says whoever holds this contract has the right to sell stock to me at 50 and I give it to you. What's the scenario there? What's the relationship? You have the contract, and the contract is the right to sell at 50. Now if you exercise the contract, that's where my obligation comes into play. I must buy the stock from you at 50 if you have the right to sell it to me at 50. 00:01:41 And that's how you want to think about the two sides of the option. The contract itself is the right to sell, but whoever creates it has the obligation to do the opposite, which is the obligation to buy. So let's get back to the numbers A50 put when the market prices at 46 has $4.00 of intrinsic value. And that should probably make sense if you have a contract that lets you sell stock for $4 higher than what the market is offering, 50 bucks versus 46. 00:02:10 That is what intrinsic value represents. You could go to the market, buy stock for 46 in the market, exercise the option and sell the stock at 50 and make a $4 profit. And again, intrinsic value is the value received by the holder upon the exercise of the contract. Now I'm going to throw a wrench into the mix and hopefully you don't get lost. Intrinsic value is the same amount on both sides of the option contract. So with the numbers we have up here. 00:02:40 50 put market prices at 46, the long side of the contract, $4.00 of intrinsic value, the short side of the contract, $4.00 of intrinsic value. Intrinsic value is always the same on both sides, but the way we look at it is it's good for the long side, bad for the short side. 00:03:01 Investors that go long option contracts want those contracts to gain intrinsic value. And investors that write, go short, or sell option contracts do not want their contracts to gain intrinsic value. When investors sell options, they want those options to expire worthless, and they're only going to expire if they do not have intrinsic value. We also call that out of the money. Here's another complication. 00:03:26 Intrinsic value does not involve the premium directly. Now here's a tricky thing. The intrinsic value influences the premium, but the premium is separate from intrinsic value. So for example, our fifty put market prices at 46, The premium could be 4, it could be 7, it could be 10, it could be 12, it could be 20, it could be any of those numbers and the intrinsic value would still be 4. 00:03:52 Now, it wouldn't make any sense for this option premium to be trading for less than $4. That is its bare bones minimum value and the market would never let it trade below that. As soon as the premium started approaching for there'd be a lot of demand for the option contract, which would push the premium back up. More demand means higher prices. You know that already. The premium is the cost of buying the contract or the money received when selling the contract. An intrinsic value is the value received by the holder upon the exercise of the contract. So those are two different. 00:04:22 Thanks. I'm going to throw in another complication. Intrinsic value does not necessarily mean rofit. In fact, you should know that already. Intrinsic value on the short side could very well mean loss. 00:04:36 Not always, but it could mean loss on the long side. Intrinsic value doesn't always mean gain. Let's go back to our original numbers to demonstrate this. Let's say an investor originally purchases this 50 put for a $7.00 premium. A few months later Mark price falls to 46 and they have $4.00 of intrinsic value in the exercise. What would happen there is they would go to the market, buy stock at 46, exercise the option, sell the stock at 50, make $4.00 of intrinsic value. 00:05:04 But that $4.00 of intrinsic value does not completely offset the $7.00 premium, and in fact the investor would result in a $3 per share loss. If they're dealing with one option contract, it'd be a three dollar loss times 100 shares, or a $300.00 overall loss. So again, it's important that you remove intrinsic value from profit. An investor with a long option can have intrinsic value. 00:05:28 But they could be profiting. They could be losing. We have to know the full picture to understand if they have a profit or a loss. Here's one last thing to think about with this concept. And then we're going to look at a practice question together to implement what we've learned. The term call up, put down is a really valuable term in this space. 00:05:46 So let's focus on that put down part. Put down means that puts gain intrinsic value when the market price goes down below the strike price. Using the same numbers, when the strike price is 50, the market price is 46. Market price is down below the strike price and therefore has intrinsic value. If the market price was above 50, let's say it was at 53, the option would have no intrinsic value and in fact we would say the option is out of the money by three dollars. 00:06:15 If the market price was 50, we'd say the option is at the money, whether the option is out of the money or at the money. Either way, it doesn't make sense for the investor who has long the option to exercise it. Holders of options only exercise their contracts when they have intrinsic value, and puts have intrinsic value when the market price goes down below the strike price put down. OK, let's look at a question, see if we can implement what we know. 00:06:41 I'm going to go ahead and put it on the board if you want. Feel free to pause the video, see if you can answer it on your own and then we'll look at it together as soon as you hit play. OK, let's look at the question first. Let's read it together. An investor goes long one ABC Jan 75 put at six when the market price is at 77. 00:07:00 A few months later, the investor closes the contract in intrinsic value. When the market is at 71, what is the gain or loss? Let's focus on this on a sentence by sentence basis, knowing that we're looking for the overall gain or loss. First sentence, we have our 75 put bought for a premium of six when the market price is 77. Now the market price is above the strike price. 00:07:22 Put down is not happening here. So the option in the beginning has no intrinsic value. In particular, it's out of the money by $2.00, so that $6 premium is 100% time value. An investor that buys an option without intrinsic value is just paying for time. Hey, I can sell this stock at 75. Currently the market price is 77, so it makes no sense for me to use this now, but I'm hoping sometime between now and the end of January. 00:07:49 That the market price goes below 75, far enough for me to profit. Hopefully it goes all the way to 0. Long puts her bearish securities, as you know. Second sentence tells us hey, few months later, investor closes the option at intrinsic value. When the market prices at 71. When a question says an investor closes the contract at intrinsic value, closing doesn't necessarily mean buy or sell. It just means that they're getting rid of the contract. And what you have to be aware of is what they did upfront. We're going to play a game of opposites here. 00:08:19 If an investor goes long an option contract or holds or Simply put buys an option contract upfront specifically, we would call that an opening purchase. The only way they can get rid of it later is if they perform what we call a closing sale. 00:08:34 Conversely, an investor that goes short or writes an option contract upfront, that would be an opening sale. The only way to get rid of that option later would be by going back to the market and buying back the same contract, kind of like selling short. And we would call that a closing purchase. Now this question involves the investor going long upfront. So they did a opening purchase upfront and to get rid of the option later, they'll need to do a closing sale. The important part here is that they'll be selling the option contract to close it out. We just need to. 00:09:04 Figure out for how much put down puts gain intrinsic value as the market price falls below the strike price. Strike price is 75, market price is 71. This option has $4.00 of intrinsic value. So we know on the back end here they'll be selling this option contract to get rid of it for a premium of four and now we can figure out what the gain on loss is. They went long or bought the original investment through a opening purchase at six and then sold the option later through a closing sale for. 00:09:34 Or a premium of four, buying at six, selling at four later. That's a $2.00 per share loss. Every contract covers 100 shares of stock. $2.00 loss per share times 100 shares per contract gets us to a $200.00 overall loss that the investor incurs. And sure enough, that is our answer.
