Introduction to Corporate Finance

8: Options

Options traders say that a call option is in the money if the option’s strike price is less than the

current share price. For puts, an option is in the money if the strike price exceeds the share price.

Using these definitions, we can say that the call options in the upper three rows of Table 8.1 are in

the money, whereas the put options in the lower six rows are in the money. Similarly, options traders

say that a call option is at the money when the share price and the strike price are equal. In Table

8.1, the St Kilda Optics options, with a strike price of $30, are at the money because the share

price is $30.00.

TaBle 8.1 OPTION PRICE QUOTES FOR ST KILDA OPTICS

The table lists prices for call and put options that expire in April, May and July, with strike prices of $27.50, $30.00, $32.50
and $35.00.

Company Expiration Strike Calls Puts

30.00 April 27.50 3.26 0.67

30.00 May 27.50 3.91 1.23 Out-of-the-money puts, in-the-money calls

30.00 July 27.50 4.91 2.04

30.00 April 30.00 1.77 1.67

30.00 May 30.00 2.53 2.33 At-the-money puts and calls

30.00 July 30.00 3.62 3.23

30.00 April 32.50 0.85 3.24

In-the-money puts, out-of-the-money calls

30.00 May 32.50 1.55 3.83

30.00 July 32.50 2.62 4.69

30.00 April 35.00 0.36 5.24

30.00 May 35.00 0.90 5.67

30.00 July 35.00 1.86 6.40

Take one more look at the May call option, with a strike price of $27.50. If an investor who owned

this option exercised it, she could buy St Kilda Optics shares for $27.50 and resell them at the market

price of $30.00, a difference of $2.50. But the current price of this option is $3.91, or $1.41 more than

the value the investor would obtain by exercising it. In this example, $2.50 is the option’s intrinsic value.^5

You can think of intrinsic value as the profit an investor makes from exercising the option (ignoring

transactions costs as well as the option premium). If an option is out of the money, its intrinsic value is

zero. Therefore, a call option’s intrinsic value equals the share price minus the strike price (S–X) or zero,

whichever is greater. For a put option, the intrinsic value equals either zero or the option’s strike price

minus the share price (X–S), whichever is greater. The difference between an option’s intrinsic value and

its market price ($1.41, for the May call) is called the option’s time value. At the expiration date, the time

value equals zero.

5 The intrinsic value of each of the three call options, with a strike price of $30, is $0. For put options, the intrinsic value equals
either X-S or $0, whichever is greater. For example, the intrinsic value of each of the three put options, with a strike price of $35,
is $5 ($35 – $30).

in the money

A call (put) option is in the

money when the share price

is greater (less) than the strike

price

at the money

An option is at the money

when the share price equals

the strike price

intrinsic value

The profit that an investor

makes from exercising an

option, ignoring transactions

costs and the option premium

out of the money

A call (put) option is out of

the money when the share

price is less (greater) than the

strike price

time value

The difference between an

option’s market price and its

intrinsic value