How to calculate the intrinsic value of Call options – FINRA SIE, Series 7

Tyler York

What’s the value of your call 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. 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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Full How to calculate the intrinsic value of Call options – FINRA SIE, Series 7 video transcript:

Let's talk intrinsic value in the money, exercise value, all that's pretty much the same thing and we will specifically focus on how those terms relate to calls in this video. First, let's start as easy as we can. Intrinsic value represents the value received by the holder, the long side of the option contract when they exercise their option. And what we're doing is comparing the right of the option.
To what the market provides, if that doesn't make sense, let's use some numbers to better describe what we're talking about. A 70 call has $5 of intrinsic value when the market price is at 75. Now a 70 call contract is the right to buy stock at 70. And I already know what you're thinking. Aren't there two sides to every option contract? Yes, there are always two sides to an option contract.
But as a contract itself, a 70 call provides the right to buy stock at 70. A lot of people think of calls kind of like a coupon that you get through a store. So for example, let's say that there is a coupon to buy, I don't know, a TV for 70 bucks. That'd be pretty good deal. So a store puts out a coupon to buy a TV for 70 bucks. What is that coupon? The coupon is the right to buy the TV for 70 bucks.
If we think about it, the store that created that coupon has the obligation to sell that TV for 70 bucks. So again, the coupon itself is the right to buy a TV at 70 bucks. But the person that wrote that coupon or created that coupon has the obligation to sell that TV for 70 bucks. And that's kind of how you want to think about an option. A70 call is the right to buy stock at 70. And if you hold that option or own that option, you own that right.
But there's also another side. The person that wrote that option, the seller of that option has the obligation to sell stock at 70 should they get exercised. And that's a big if not every option is exercised. We might get to the expiration date and there might not be any intrinsic value and would might not make any sense for the holder to exercise their contract. But let's get back to the original example. A 70 call has $5 of intrinsic value when the market is at 75.
It's because that call gives the right to buy at 70 when the market is offering the same security for 75. Now, here's something that might be kind of difficult to do. You need to remove intrinsic value from the term good, meaning that intrinsic value is not always a good thing. Let's clarify intrinsic value is good for the long side.
Meaning that an investor that purchases an option wants to gain intrinsic value. They want to exercise their option, otherwise they spent money on something that just expires. But the person that wrote the option contract that sold the option contract, They don't want intrinsic value.
Intrinsic value is bad news to them because intrinsic value means they're likely going to have to fulfill their obligation. And whenever a writer, a seller of an option contract, has to fulfill their obligation, they are losing some amount of money. They might not end up with an overall loss, but when an option is exercised, the writer is losing some amount of money. If they lose more than the original premium they received upfront, that is when they have an overall loss. So with all that being said, let's summarize the point.
Intrinsic value is good for the long side, bad for the short side. Now something else that you should keep in mind, intrinsic value does not directly involve the premium and that's kind of tough to say on the surface. The premium and the intrinsic value are connected. The intrinsic value of an option influences the premium of the option, but intrinsic value itself does not involve the premium. So for example, with our numbers here.
70 call when the market price is at 75, that's $5 of intrinsic value And that would be the case whether the option had a premium of six or a premium of nine or a premium of 15. Now the option in this example would never have a premium of less than five if you were to breakdown the premium.
Premium is equal to intrinsic value plus the time value of the option. If the intrinsic value is five, the premium is always going to be at least $5. The more time an option has until it expires, the more time value it has and the more expensive the overall premium is. The option would never have a premium of less than five, but the premium could literally be any number above 5. Intrinsic value only relates to the value that the option provides upon.
Exercise and if the holder of the option has the right to buy stock at 70 when the market price is offering the same stock for 75, that's again $5 of intrinsic value and that's all we're focusing on. Another thing to be aware of is that intrinsic value does not necessarily mean profit. The investor can exercise the option and buy stock at 70 and sell that stock for 75 in the market making a $5 per share profit, but if the premium.
Cost the equivalent of $6 per share. They're losing a dollar per share, and given that every option contract covers 100 shares, that would be a $100 overall loss per contract. Again, I'm going to sound like a broken record, but the intrinsic value only reflects the value of the option to the holder upon the exercise of the contract if they spent a bunch of money on the option premium and made less back when they exercised.
They're losing. So again, intrinsic value should not be tied to profit. A holder of a contract can have intrinsic value and both be profitable or unprofitable. It really depends on the big picture.
There's one more thing that we need to cover and then we're going to look at a practice question together to implement the stuff we've learned in this video. In the achievable materials, we use the term call up, put down. We didn't make up this term. This term has been around in the options markets forever and it's a great term to remember. So let's focus on the call up. Part of it calls gain intrinsic value when the market price goes up above the strike price, call up.
And that's the case with our example. If we have a 70 call when the market price is 75, that is five points above the strike price call up. The option has intrinsic value. Now if the market price was anywhere below 70, we would say that it has no intrinsic value. Let's say the market price was at 68.
It would have no intrinsic value and in particular we would say that the option is out of the money by two bucks. If the market price was at 70, the option would be at the money. Still, it would make no sense for the option holder to exercise their option contract. I mean why would they want to buy stock at 70 through their option when they could just go to the market and buy it the same price? And by the way, a lot of broker dealers charge exercise fees when they exercise options.
So if it doesn't have intrinsic value, the investor is just not going to exercise the option contract. And that is why call up is such a valuable term. Calls are only exercised if the market price is above the strike price. Keep in mind, intrinsic value is not a good thing for the short side, but it would still be the same scenario if the market price is above 70. The option still has intrinsic value, it's still in the money, but if we're looking at it through the lens of the writer, the short side, we use all.
Same terminology. It's just that terminology is bad for them. If you're short an option, you don't want it to gain intrinsic value. You don't want it to go in the money, and if it does, you're losing some amount of money. The question is, do you lose more than the premium received upfront? OK, we talked about a lot of stuff there. Let's take a look at a practice question together to better understand this concept. Here it is. If you want to take a moment and see if you can answer it on your own, pause the video and then we'll reconvene as soon as you hit play.
OK, let's look at the question together. 1 long Dow June 75 call is trading at $5.75 when the market price of Dow is $76.75. What is the options intrinsic value and time value?
First thing that we should do is reestablish that premium formula because that's what we need to know in this question. The premium is equal to the intrinsic value plus the time value of the option. We already know what the premium is. It is 575. So let's plug that in on the left side of the formula. And now we just need to figure out what is the intrinsic value, what's the time value? Let's go back to the term we originally used, call up, put down calls, gain intrinsic value when the market price rises up.
Above the strike price of the option, and that is what we're dealing with here. The strike price is 75, the market price is 7675. The option is in the money by $1.75 in the money and intrinsic value of the same thing. So we'll go ahead and plug that in. Our intrinsic value is $1.75. From there we can just do some simple algebra to figure out what the time value is.
And the only number that we could plug in that would give us a total premium of $5.75 would be a four dollar time value. Now we didn't talk much about time value, but time value represents the value of the option that is just associated with time. This option gives the holder the right to buy stock at 75 when the market price is 7675. So if an investor bought this option, they immediately gain $1.75 of value over the market on a per share basis.
They can buy 100 shares of stock at 75 and sell those 100 shares immediately in the market as 7675, making a profit of $1.75 per share. When we bring it back to the premium, what we're really doing is we're asking ourselves what is the investor paying for when they buy the option? Yeah, the option gives them immediate value, intrinsic value or in the money amount of $1.75.
O anything above that is considered time value. The investor's essentially paying for time and hopes that the market rice continues to rise above 75. The higher it rises, the more profit they make.
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