Intrinsic value (finance)

Options

For an option, the intrinsic value is the absolute value of the difference between the current price (S) of the underlying and the strike price (K) of the option, to the extent that this is in favor of the option holder. Thus, the option is said to have intrinsic value if the option is in-the-money; when out-of-the-money, its intrinsic value is zero. For an option, then, the intrinsic value is the same as the "immediate value" or the "current value" of the contract, which is the profit that could be gained by exercising the option immediately. Formulaically:

${\displaystyle I{V}_{\text{out-of-the-money}}=0}$

${\displaystyle I{V}_{\text{in-the-money}}=\left|S-K\right|=\left|K-S\right|}$

For example, if the strike price for a call option is USD 1.00 and the price of the underlying is US$1.20, then the option has an intrinsic value of US$0.20. This is because that call option allows the owner to buy the underlying stock at a price of 1.00, which they could then sell at its current market value of 1.20. Since this gives them a profit of 0.20, that is the current ("intrinsic") value of the option.

The market price of an option is generally different from this intrinsic value, due to uncertainty: as alluded to, it is based on the current market value of the underlying instrument, but ignores the possibility of future fluctuations. Further, options are valid for a duration of time, so investors may buy or sell options contracts on their belief in the likelihood that the value of the stock will change before the option's expiration date. This is called the option time value. For example, while an out-of-the-money option has an immediate/intrinsic value of zero, since exercising the option would not be profitable at the current time, the option could still be sold at nonzero price to an investor who speculates that the option might become in-the-money before it expires, due to a change in the value in the underlying stock.

This describes what happened in one GameStop options trade that became famous: a trader spent $53,000 buying a large number of call options that were extremely cheap, since they were so far out-of-the-money that other traders thought it was very unlikely that they would ever hold intrinsic value. However, these options had an expiration date far in the future, and two years later the underlying GameStop shares spiked in value, putting the options in-the-money, which the trader was able to exercise for $48 million.