What is Intrinsic Value of an Option?

The intrinsic value (IV) of the option upon expiry (specifically a call option for now) is defined as the non – negative value which the option buyer is entitled to if he were to exercise the call option.

In simple words ask yourself (assuming you are the buyer of a call option) how much money you would receive upon expiry, if the call option you hold is profitable. It defined the Moneyness of an Option. 

Mathematically, it is defined as-
 Intrinsic Value of a Call = Spot Price – Strike Price
Intrinsic Value of a Put = Strike Price – Spot Price

Understanding Of Intrinsic Vale with an Example

So if Ibulhsgfin on the day of expiry is trading at 740 (in the spot market) the 720 Call option’s intrinsic value would be-
= 740 – 720
= 20

Likewise, if Ibulhsgfin is trading at 718 on the expiry day the intrinsic value of the option would be-
= 718 – 720
= -2
But remember, IV of an option (irrespective of a call or put) is a non-negative number; hence we leave the IV at 718
= 0

Now our objective is to keep the idea of intrinsic value of the option in perspective, and to identify how much money I will make at every possible expiry value of Ibulhsgfin and in the process make some generalizations on the call option buyer’s P&L.

Points to Note
  • For a call option buyer, a loss occurs when the spot price moves below the strike price. However, the loss to the call option buyer is restricted to the extent of the premium he has paid
  • The profit from this call option seems to increase exponentially as and when Ibulhsgfin starts to move above the strike price of 720
  • The call option becomes profitable as and when the spot price moves over and above the strike price.
  • The higher the spot price goes from the strike price, the higher the profit.
  • It is fair for us to say that the buyer of the call option has a limited risk and a potential to make an unlimited profit.

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