When it comes to option trading, intrinsic value (I.V.) indicates a difference between the exercise price (strike price) and the security market value. In 1934 Benjamin Graham, a professor from Columbia, coined the concept of a margin of safety.
Professor Graham introduced the idea of calculating the I.V of a stock. He demonstrated this idea by examining the assets of a particular company and its earnings. This concept allowed him to forecast the future earnings of that company.
You will often hear that an option has intrinsic value if it is in the money. It suggests that this prospect has a positive monetary value. To calculate it, one has to define both “put” and “call” options.
Put option
A put option is a difference between a strike and stock price. I.V will always be zero if the option is either at the money or out of the money. The equation below helps determine the put option.
Intrinsic value of put option = (Exercise price – Underlying security price)
Call option
A call option is defined as an I.V that is equal to a stock’s price, less the exercise price. This next equation helps determine the call option.
Intrinsic value for the call option = (Underlying security price – exercise price).
Putting it all together:
Use this example to better understand how call and put options can be implemented in option trading.
Say the call option exercise price is $200 and the market price of an underlying security is $300. This takes the call option to $100.
Supposing that an investor or trader buys a put option with an exercise price of $250 for $100 while the security is trading at $150, then the put option intrinsic value will be $100 ($250 – $150).
Now, let’s continue assuming the investor purchases a put option with the exercise price of $100 for $10. With the underlying security price at $150, the intrinsic value for a put option is zero. It therefore can be inferred that it is now out of the money.
Buyers will not be interested in options that are out of the money, because it inevitably results in a loss. In this case, the buyer has to let the option expire, even without getting a payoff.
Intrinsic Value is important
Intrinsic value allows investors to understand more about the security they plan to purchase. This is happens when investors aim to locate stocks that are trading less below their intrinsic value.
This also helps to differentiate between value and growth investors. Growth investors often depend on earnings estimates. This makes their earnings unreliable because they can either be too high or even wrong,
However, value investors purchase securities that sell at a better discount. Value investors often wait for prices to increase so they can profit. Regardless the different outcomes, both growth and value investors purchase securities in hopes that the market price of the security will rise and match the intrinsic value.
Putting it all together
Understanding intrinsic value of a security can be a big benefit to traders and value investors. It enables them to purchase securities at discounted price and lets them profit from the difference. Value investors use discounted cash flow analysis, asset-based valuation and other metrics like price-to-earnings ratio to determine a security’s I.V.
