1. Option Basics 1.1 Introduction

An option’s total premium is comprised of intrinsic value and time value. An option’s intrinsic value is equal to the amount the option is in the money. Time value is the amount by which an option’s premium exceeds its intrinsic value. In effect, the time value is the price an investor pays for the opportunity to exercise the option. An option that is out of the money has no intrinsic value; therefore, the entire premium consists of time value.

Example:

An XYZ June 40 call is trading at \$2 when XYZ is trading at \$37 per share. The June 40 call is out of the money and has no intrinsic value; therefore, the entire \$2 premium consists of time value. If an XYZ June 40 put is trading at \$3 when XYZ is at \$44 dollars per share the entire \$3 is time value.

If in the above example the options were in the money and the premium exceeded the intrinsic value of the option, the remaining premium would be time value.

Example:

An XYZ June 40 call is trading at \$5 when XYZ is trading at \$42 per share. The June 40

call is in the money and has \$2 in intrinsic value; therefore, the rest of the premium consists of the time value of \$3. If an XYZ June 40 put is trading at \$4 when XYZ is at

\$39, the put is in the money by \$1 and the rest of the premium or \$3 is time value.

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Introduction

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