Understanding the Value of Stock Options
Simply stated, there are two components that make up the value of a stock option. In order to better understand the value of stock options we need to become familiar with these two components referred to as the intrinsic value and the time value.
Breaking it down to the next level, we define the intrinsic value as the difference between the current stock price and the exercise price.
For example: Let’s examine the event of 5,000 stock options issued at $25 per share. At the time of exercise, the current price of the stock is $40 per share, thus, putting the intrinsic value at $75,000 (($40-$25) X5000). This factor is often referred to as the bargain element.
Progressing along to the time value of the option, we can represent that the time value is the value based on the potential increase in the stock, between now and the expiration of the option. Keep in mind that in general, most options have a life of 10 years. The longer the option has until expiration the greater the time value. Furthermore, the time value will continue to diminish over time and at expiration the time value becomes zero.
When we tie it all in together, it is important to remember that the time value of an option can vary drastically depending on the expiration, as well as the volatility.
Dan’s Moral: The value of stock options can be worth more than the intrinsic value. Be careful not to be discouraged by the current cash-in-value (intrinsic value) of your options as the overall value when including the time value may be much higher.
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