Derivatives · Intermediate · 4 min

Intrinsic value and time value

You can split an option's premium into intrinsic and time value, tell in-, at- and out-of-the-money options apart, and explain why time value shrinks.

Value plus hope

An option costs 11. If you could exercise it right now, it would be worth 8. Why would anyone pay 3 more?

The answer is time. As long as an option has time left, it might become worth more. That possibility has a price, and that price slowly disappears. This lesson splits an option's premium into its two parts and explains why one of them melts.

Intrinsic + time

Every option premium can be split into two parts:

Intrinsic value is what the option would be worth if exercised immediately. For a call, it is the amount by which the underlying is above the strike. For a put, the amount by which it is below. It can never be negative.
Time value is the rest of the premium: payment for the chance that the option becomes more valuable before expiry. It depends on time left, volatility and interest rates.

An option's relation to the current price is called its moneyness:

In the money: the option has intrinsic value. A call with strike 100 on a stock at 108.
At the money: strike and price are about equal. Time value is usually highest here.
Out of the money: no intrinsic value, only time value. A call with strike 120 on a stock at 108.

Time value shrinks as expiry approaches. The Options Industry Council explains that options lose value over time even in a stable market, that the decay accelerates as expiration nears, and that at expiration, only intrinsic value is left.

For buyers, that means the underlying must move enough, and soon enough, to outrun the decay. For sellers, time decay is the source of their income, in exchange for the risk of a large move.

Right direction, still −3

A fictional stock trades at 108. A call with a strike of 100 and one month to expiry costs 11.

Intrinsic value: 108 − 100 = 8. Time value: 11 − 8 = 3.
The stock stays at 108 until expiry. The call ends worth 8.
The buyer paid 11, so the result is a loss of 3, even though the stock was above the strike the whole time.

For an out-of-the-money call with a strike of 120, priced at 1, the whole premium is time value. If the stock does not rise above 120, all of it is lost.

Common mistakes

Buying cheap out-of-the-money options as lottery tickets. Most expire worthless.
Ignoring time decay. Waiting costs money every day.
Thinking in the money means profitable. The premium paid can still exceed the intrinsic value.
Holding options into the last weeks without a plan. Decay is fastest then.

The takeaway

An option's price is intrinsic value plus time value. Intrinsic value is what it's worth now, time value pays for what might happen, and it melts away.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the part of the premium that will be zero at expiry.

Tap the chart.

At expiry, only intrinsic value remains. The OIC notes that the extrinsic part decays to zero.
2A put has a strike of 50, the stock trades at 54. What is its intrinsic value?

A put has intrinsic value only below the strike. At 54, it is out of the money, so its whole price is time value.
3When does time value usually decay fastest?

The OIC explains that the rate of decay accelerates as expiry nears.
4What does 'at the money' mean?

At the money, the option has little or no intrinsic value, and its time value is usually highest.

of 4 correct.