|The value or premium of any option can be divided into two elements:
The Intrinsic Value is the value that the option would have should it be exercised immediately.
So, for example, a call option on HSBC shares with an exercise price of 800p would have 50p of Intrinsic Value if at that time the HSBC share price was 850p. This is because the value to the option holder of exercising the option at that time would simply be the difference between the exercise price and the current share price i.e. he could buy the shares at 800p by exercising the option and make an immediate profit of 50p by selling them in the market at 850p.
The Intrinsic Value is the minimum value any option can have since it would be illogical for any option seller to sell an option for less than its intrinsic value.
The second element of an option's value is called the Time Value and represents the uncertainty about whether the option will be exercised or not.
An option that is either very certain to be exercised or very certain not to be exercised, will have very little Time Value.
On the other hand an option for which there is significant uncertainty over whether it will or will not be exercised, will have a lot of Time Value.
When is this uncertainty greatest?
The uncertainty is greatest in three cases:
a) When the exercise price is very close to the current price of the underlying asset
In this case, it is clear that if an option has say, one day to go until maturity and the underlying asset price is equal to the exercise price then it is very uncertain if the option will be exercised or not. In this case only a very small movement in the price of the underlying could change the decision on whether to exercise or not.
Furthermore if the current underlying asset price and the exercise price were exactly equal then the option would have zero Intrinsic Value. Nevertheless no seller would offer the option for zero as it could very easily be exercised the next day. The option's value, and hence its premium, would therefore be made up entirely of Time Value.