Capital Market Chronicles – Episode 193: OPTIONS PREMIUM (Part II)

🧮 Capital Market Chronicles – Episode 193: OPTIONS PREMIUM (Part II)

Breaking Down the Price Tag — Intrinsic & Extrinsic Value

If options were movie tickets to future profits, the option premium is the price you pay for that ticket. But what’s inside that price? It’s not just random digits on a trading screen — every premium has two key ingredients: intrinsic value and extrinsic (time) value. Together, they form the backbone of options pricing. Let’s unpack them. 🎟️

💰 1️⃣ Intrinsic Value – The “Right Now” Profit

Think of intrinsic value as the real money hidden inside an option — the profit you’d make if you exercised it right this moment.

It’s calculated as the difference between the current market price (spot price) and the strike price (the price fixed when you bought the option).

• Call Option: Has intrinsic value when the spot price > strike price.
  👉 Example: If Infosys is trading at ₹1,000 and your call option strike price is ₹950, your intrinsic value is ₹50.

• Put Option: Has intrinsic value when the spot price < strike price.
  👉 Example: If Infosys trades at ₹950 and your put option strike price is ₹1,000, your intrinsic value is ₹50.

If the option is Out of the Money (OTM) — meaning exercising it won’t make sense — then the intrinsic value is zero. (Sorry, wishful thinking doesn’t count as profit! 😅)

⏳ 2️⃣ Extrinsic Value – The “What If” Potential

Now for the exciting part — extrinsic value, also known as time value. This is the extra amount traders are willing to pay for possibility.

It represents the hope that the option will move in a profitable direction before expiration. Time value gradually shrinks as expiry approaches — a phenomenon traders call “time decay.”

Two main forces power this value:

• 🕰️ Time to Expiry:
  The longer the duration, the higher the chance that prices might swing in your favor — hence, a higher time value.

• 🌪️ Volatility:
  Volatile markets mean bigger price swings, which translate into higher chances for profit — and yes, a higher premium too.

💡 Example: Infosys Call Option

Let’s put it all together with a simple example:

• Spot Price: ₹1,000

• Strike Price: ₹950

• Option Premium: ₹70

Now let’s break that ₹70 down:

• Intrinsic Value: ₹50 (₹1,000 – ₹950)

• Extrinsic Value (Time Value): ₹20

So, ₹70 = ₹50 (real profit) + ₹20 (hope, time, and market buzz).

⚙️ Why This Matters

Understanding these two components is crucial because they show what you’re really paying for: part present value, part future potential.

• Intrinsic value = tangible profit now.

• Extrinsic value = the “maybe” you’re betting on.

Together, they tell you whether you’re investing smartly — or paying too much for the dream.

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