Determining the value of a stock option involves looking at two distinct parts. One part, known as the intrinsic value, is calculated by determining the profit that’s created by the option. As an example, if an option allows you to buy a stock at $15 per share that’s valued at $25 per share, that option is said to have a $10 per share intrinsic value.
The option also holds additional value as it can be held for potentially greater profits. You don’t have to exercise your option until the expiry period (if at all), so if there is still time left before the option expires, your option could potentially go up in value before you ever pull the trigger and exercise it. This may be referred to as the time value of an option. The true value of an option is the combination of intrinsic value and the time value. Option value can be useful to know, but in no way determines the future of an option. Options can rapidly appreciate and depreciate in value.
The real formula to determine an options value is extremely complicated, but you can get a rough estimate using the following formula:
To find out the intrinsic value, subtract the exercise price (strike price multiplied by number of shares) from the present value of the shares at the market rate. Next, take the exercise price and multiply it by 0.25 (25%) to get an estimated time value in five years time (reduce this number proportionally if less than 5 years). Combine both the intrinsic value and the time value to get a rough estimate of what your option is worth.
For example, your option is $20 per share on a $32 stock that will expire in 4 years. Five-year time value would be $5, reduced by one fifth for being only 4 years (reduced to $4). The value would then be $12 (intrinsic value) + $4 (time value) equaling $16 per share.