In option trading, intrinsic value (I.V.) refers to the difference between the exercise price (strike price) and the market value of a security. Professor Benjamin Graham from Columbia is credited for having conceptualized the margin of safety concept.
This happened in 1934 and resulted in the good professor introducing the idea of calculating the I.V of a stock. The professor demonstrated his idea by analyzing the assets of a company and earnings. This resulted in him forecasting the future earnings of the company.
It is said that an option has an intrinsic value if it’s in the money. This means that the option has a positive monetary value. To calculate this, we have to define both put and call options.
This is defined as the difference between strike and stock price. If the option is at the money or out of the money, I.V will be always zero. Use the equation below to determine the put option.
Intrinsic value for put option = (Exercise price – Underlying security price)
When it comes to the call option, I.V is equal to the price of a stock less the exercise price. Use the equation below to determine the call option
Intrinsic value for call option = (Underlying security price – exercise price)
How It Works
Here is an example to help you understand how the above are implemented in option trading.
Let’s assume the call option exercise price is $20 and the market price of an underlying security is $30. This means the call option is $10.
If we were to assume that a trader or investor buys a put option that has an exercise price of $25 for $10 while the security was trading at $15, the put option intrinsic value will be $10 ($25 – $15).
Let’s also assume that the investor opts to purchase a put option with an exercise price of $10 for $1. Since the underlying security price is $15, the intrinsic value for a put option would be zero. As a result, it can be concluded that it is out of the money.
For options that are out of the money, buyers will not be interested because it will result in a loss. What the buyer will do is let the option expire thus getting no payoff.
Why Intrinsic Value Matters
For starters, it helps investors understand more about the security they are intending to purchase. This is because investors have the following goal in mind – to locate stocks that are trading less than their intrinsic value.
Secondly, it helps to distinguish between growth and value investors. Growth investors are known to rely on earnings estimates.
These earnings can either be too high or wrong making them unreliable. On the other hand, value investors purchase securities that are selling at a discount. To profit, value investors will wait for the price to increase in order to profit. Despite the difference, both investors – value and growth – purchase securities expecting the market price of the security to rise and match the intrinsic value.
Learning the intrinsic value of a security is very useful especially for value investors. This enables value investors to purchase securities at a discount and profit from the difference. There are other measures that value investors use to determine a security’s I.V. They include discounted cash flow analysis, asset based valuation and use of metrics like price-to-earnings ratio.