Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksHard
An investor purchases a call option with a strike price of $50 for a premium of $3. The underlying stock is currently trading at $52. What is the intrinsic value of this call option?
- A$5
- B$3
- C$0
- D$2
Show answer & explanationAnswer & explanation
Correct answer: D. $2
The intrinsic value of a call option is the amount by which the underlying stock's market price exceeds the option's strike price. For a call, Intrinsic Value = Market Price - Strike Price. Here, $52 (market price) - $50 (strike price) = $2. The premium paid ($3) is the extrinsic value (time value) plus intrinsic value, but not the intrinsic value itself.
Why the other options are wrong
- A. This is a distractor, possibly from adding premium to intrinsic value or other incorrect calculations.
- B. This is the premium paid, which includes both intrinsic and extrinsic value, not just intrinsic value.
- C. This would be the case if the stock price was at or below the strike price.
Intrinsic Value of an Option
The portion of an option's premium that is in-the-money. For a call, it's the amount the stock price is above the strike price; for a put, it's the amount the stock price is below the strike price.
- Intrinsic value cannot be negative (minimum is $0).
- Call option intrinsic value = Market Price - Strike Price (if positive, else 0).
- Put option intrinsic value = Strike Price - Market Price (if positive, else 0).
- Option premium = Intrinsic Value + Time Value (Extrinsic Value).
Memory trick: Intrinsic Is In-The-Money; Time is Tomorrow's Tremor.