Options Pricing: Intrinsic Value And Time Value
The two components of an option premium are the intrinsic value and the time value. The intrinsic value is the difference between the underlying's price and the strike price. 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 inthemoney. For calls, inthemoney refers to options where the exercise (or strike) price is less than the current underlying price. A put option is inthemoney if its strike price is greater than the current underlying price.
IntheMoney (Call) = Strike Price < Underlying Price 
IntheMoney (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 total 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 contract, which is equal to 100 shares). If the option has an intrinsic value of $7.00, its time value would 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 that the option position has to become more profitable due to a favorable move in the underlying price. In general, 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 can 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 
RELATED TERMS

Time Value
The portion of an option's premium that is attributable to the ... 
Intrinsic Value
Intrinsic value is the actual value of a company or an asset ... 
LargeValue Stock
A type of largecap stock investment where the intrinsic value ... 
Option Premium
1. The income received by an investor who sells or "writes" an ... 
Out Of The Money  OTM
A call option with a strike price that is higher than the market ... 
Deep Out Of The Money
An option with a strike price that is significantly above (for ...
RELATED FAQS

What role does intrinsic value play in put options?
See why the concept of intrinsic value is so important in options trading and how investors use it to evaluate the worth ... Read Answer >> 
What role does intrinsic value play in call options?
Understand why the concept of intrinsic value is important for options traders and how they can use it to estimate what a ... Read Answer >> 
What happens when a security reaches its strike price?
Learn more about the moneyness of stock options and what happens when the underlying security's price reaches the option ... Read Answer >> 
When is a call option considered to be "in the money"?
Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >> 
How do I change my strike price once the trade has been placed already?
Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >> 
Do you always have to consider intrinsic value when purchasing a stock? Why or why ...
Take a deeper look at why value investors consider a stock's intrinsic value an important consideration before picking a ... Read Answer >>
You May Also Like
Sponsored content