1. Options Pricing: Introduction
  2. Options Pricing: A Review Of Basic Terms
  3. Options Pricing: The Basics Of Pricing
  4. Options Pricing: Intrinsic Value And Time Value
  5. Options Pricing: Factors That Influence Option Price
  6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  7. Options Pricing: Modeling
  8. Options Pricing: Black-Scholes Model
  9. Options Pricing: Cox-Rubinstein Binomial Option Pricing Model
  10. Options Pricing: Put/Call Parity
  11. Options Pricing: Profit And Loss Diagrams
  12. Options Pricing: The Greeks
  13. Options Pricing: Conclusion

The two components of an option premium are the intrinsic value and time value of the option. The intrinsic value is the difference between the underlying's price and the strike price - or the in-the-money portion of the option's premium. Specifically, the intrinsic value for a call option is equal to the underlying price minus the strike price. For a put option, the intrinsic value is the strike price minus the underlying price.

Intrinsic Value (Call) = Underlying Price – Strike Price
Intrinsic Value (Put) = Strike Price – Underlying Price

By definition, the only options that have intrinsic value are those that are in-the-money. For calls, in-the-money refers to options where the strike price is less than the current underlying price. A put option is in-the-money if its strike price is greater than the current underlying price.

In-the-Money (Call) = Strike Price < Underlying Price
In-the-Money (Put) = Strike Price > Underlying Price

Any premium that is in excess of the option's intrinsic value is referred to as time value. For example, assume a call option has a premium of $9.00 (this means that the buyer pays - and the seller receives - $9.00 for each share of stock, or $900 for the 100-share contract). If the option has an intrinsic value of $7.00, its time value would then be $2.00 ($9.00 - $7.00 = $2.00).

Time Value = Premium – Intrinsic Value

In general, the more time to expiration, the greater the time value of the option. It represents the amount of time the option position has to become profitable due to a favorable move in the underlying price. In most cases, investors are willing to pay a higher premium for more time (assuming the different options have the same exercise price), since time increases the likelihood that the position will become profitable. Time value decreases over time and decays to zero at expiration. This phenomenon is known as time decay.

An option premium, therefore, is equal to its intrinsic value plus its time value.

Option Premium = Intrinsic Value + Time Value

Options Pricing: Factors That Influence Option Price
Related Articles
  1. Trading

    What Drives An Option's Price?

    The primary drivers of an option’s price are the underlying stock’s current price, the option’s intrinsic value, its time to expiration and volatility.
  2. Trading

    What Does It Mean When an Option is At The Money?

    The strike price of an at-the-money options contract is equal to its current market price. Options that are at the money have no intrinsic value, but may have time value.
  3. Investing

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value can be subjective and difficult to estimate. It’s a perception of a security’s value that factors tangible and intangible factors.
  4. Trading

    The Basics Of Option Price

    Options can be an excellent addition to a portfolio. Find out how to get started.
  5. Investing

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value reduces the subjective perception of a stock's value by analyzing its fundamentals.
  6. Insurance

    Explaining Premiums

    Premium has a few different meanings in the financial world.
  7. Trading

    The Importance Of Time Value In Options Trading

    Move beyond simply buying calls and puts, and learn how to turn time-value decay into potential profits.
Frequently Asked Questions
  1. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  2. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
  3. What's the most expensive stock of all time?

    The most expensive publicly traded stock of all time is Warren Buffett’s Berkshire Hathaway.
  4. What is a "socially responsible" mutual fund?

    As the name suggests, socially responsible mutual funds invest exclusively in socially responsible investments.
Trading Center