The cost of the call option is called the premium, and is made up of two parts: Understanding intrinsic value and time value is essential because these two values tell you when you can exercise the call option profitably. Call options work this way because you pay the strike price to buy the shares. Exercising the option has a potential for profit only if you can sell the shares for more than you pay for them, so the market price needs to be higher than the strike price.
When the market price is less than the strike price, the option is out of the money. Exercising an option that is out of the money is worse than useless, because you would pay more for the shares than they would cost if you bought them at the market price. The intrinsic value of a call option is the difference between the strike price and the market price when the option is in the money. If the option is out of the money, the intrinsic value is zero.
In other words, intrinsic value tells you how much money you keep if you exercise the option to buy the shares and sell them at the current market price. The premium is always greater than zero until the call option expires, and is always more than the intrinsic value. If you subtract the intrinsic value from the premium, the difference is the time value of the call option. Time value starts when the option contract is first sold as the amount the option seller, also called the option writer, charges to cover her costs.
This component of a call option premium is called time value because it gets smaller as the call option gets closer to its expiration date. The fact that a call option is in the money does not automatically mean you will make a profit if you exercise the option. However, you can use intrinsic value to calculate your break-even point. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in Calculating Intrinsic Value The intrinsic value of a call option is the difference between the strike price and the market price when the option is in the money.
Time Value The premium is always greater than zero until the call option expires, and is always more than the intrinsic value. Break-Even Point The fact that a call option is in the money does not automatically mean you will make a profit if you exercise the option. References Options Industry Council: What Is an Option? How Does a Put Option Work? What Is an Expired Option? More Articles You'll Love. Bull Put Spread Vs. Taxation of Covered Calls.
How to Trade Leveraged Stock Options.More...