Intrinsic Value

A customer buys 1 call, strike 30, premium 4. At expiration the stock is exactly 30. The result is:

1. A.A gain of 400 dollarsThe 400-dollar figure is right but flows the wrong direction. Premium is money the buyer paid out, and with the call finishing at the strike there is nothing coming back to offset it.
2. B.A loss of 400 dollars (the premium)Correct - premium lost when at the money.
3. C.BreakevenThis confuses the strike with the breakeven. At 30 the call has no exercise value at all, and the customer would need the stock at 34 to recover the 4 points paid.
4. D.A gain of 3,000 dollars3,000 dollars is what 100 shares are worth at 30, which is the value of stock the customer does not own and did not buy. Owning a call at the money produces no gain of any size.

Why: At the money at expiration, the call has no intrinsic value, so the buyer loses the 4-point (400-dollar) premium.

A call option whose strike price sits above the current market price of the underlying stock trades at a premium of 2. That premium consists of

1. A.intrinsic value of 2 and no time value at all.Wrong. Immediate exercise would cost more than buying the stock outright, so nothing is intrinsic here.
2. B.time value of 2 and no intrinsic value at all.Correct. With the strike above the market, everything the buyer is paying for lies in the future.
3. C.intrinsic value and time value in roughly equal proportions.Wrong. That split requires the option to be in the money, which a strike above the market is not.
4. D.neither, since an out-of-the-money option cannot command a premium.Wrong. The chance of a move before expiration is exactly what buyers are paying for.

Why: An option premium always divides into intrinsic value, which is what the holder would gain by exercising immediately, and time value, which is what the market charges for the possibility of a favourable move before expiration. A call whose strike lies above the market price would produce nothing on immediate exercise, so its intrinsic value is zero and the whole premium is time value. That is why an out-of-the-money option loses value steadily if the underlying does not move. Once the stock rose above the strike, intrinsic value would appear and the premium would split between the two components.

A client holds a long call option and the underlying stock trades at essentially the same price for several weeks. Over that period the premium on his option will generally

1. A.decline, because time value erodes as the expiration date draws nearer.Correct. Time is an input in its own right, and it is consumed whether or not the stock moves.
2. B.remain unchanged, since the price of the underlying stock has not moved.Wrong. The premium has two components, and the passage of time consumes one of them regardless.
3. C.rise, because a longer record of stability makes the option safer to hold.Wrong. Stability reduces the likelihood of the very move the option needs in order to pay.
4. D.decline, but only where the option is currently in the money.Wrong. An out-of-the-money option is nothing but time value, so it decays fastest of all.

Why: An option is a wasting asset because one of the two components of its price is the time remaining before expiration. Holding the underlying still, the passage of time removes optionality without replacing it with anything, so the premium erodes and the erosion accelerates as expiration approaches. This is why a long option position needs the underlying to move, and to move soon enough, before it can be profitable. A rise in implied volatility could offset the decay for a time, but nothing in a period of price stability supplies one.

The intrinsic value of a call option equals:

1. A.Strike minus market priceThis is the put formula. A call gains value as the stock rises above the strike, so the market price has to come first in the subtraction. Reversed, it would report value only when the call is out of the money, which cannot be right.
2. B.The premium paidThe premium bundles intrinsic value together with time value, so the two coincide only in the unusual case of an option with no time premium left. Intrinsic value is one component of the premium rather than the whole of it.
3. C.Always zeroZero is the floor on intrinsic value and is genuinely correct for any out-of-the-money call, since a right no one would exercise carries no intrinsic worth. An in-the-money call carries positive intrinsic value, so always turns a boundary into a rule.
4. D.Market price minus strike price, when positiveCorrect - in-the-money amount.

Why: A call's intrinsic value is the market price minus the strike price, when that difference is positive (in the money).