Intrinsic and time value

An option's premium is not one single, unexplained number. It can be broken into two parts, and understanding the split explains a lot about how options actually behave.

Intrinsic value is the amount by which an option is currently in the money, the profit that could be locked in by exercising it right now. Time value is everything else in the premium: the extra amount a buyer is willing to pay, over and above intrinsic value, for the chance the option becomes even more valuable before it expires.

An option that is In-The-Money has positive intrinsic value. One that is At-The-Money or Out-of-The-Money has none at all, its entire premium, if any, is time value.

Intrinsic value is the excess of the current price over the strike price, for a call option — for instance, a stock at Rs 520 against a Rs 500 strike gives Rs 20 of intrinsic value — the amount an option holder would gain by exercising immediately and closing out the underlying at the market price. Time value exists because there is still time left before expiry, during which the underlying's price could move further in the buyer's favour, so a rational buyer pays something for that possibility even beyond today's intrinsic value.

As an option gets closer to expiry, time value shrinks toward zero, because there is less and less time left for a favourable move to happen. At expiry itself, an option's premium is pure intrinsic value, with no time value left at all.

A stock trades at Rs 520. A call option on it with a strike price of Rs 500 has intrinsic value of Rs 20 (520 minus 500), the amount an investor would gain by exercising the option right now. If this call option's premium in the market is Rs 28, the remaining Rs 8 is its time value, what buyers are paying for the chance the stock rises further before expiry.

A second call option on the same stock, with a strike price of Rs 550, is Out-of-The-Money, its intrinsic value is zero, since exercising it now would mean buying at Rs 550 something worth only Rs 520. If this option still trades at Rs 4, that entire Rs 4 is time value, the market is not paying for any current profit, only for the possibility of one before expiry.

Chapter 10 (Understanding Derivatives), in the discussion introducing In-The-Money, At-The-Money and Out-of-The-Money options, defines intrinsic and time value immediately after the moneyness classification. Expect a question that gives a strike price, current price and premium, and asks for the intrinsic and time value components.

• Only an In-The-Money option has positive intrinsic value — At-The-Money and Out-of-The-Money options have zero intrinsic value, whatever their premium happens to be.
• Time value is a residual, not a separately quoted figure — it is always premium minus intrinsic value, never the other way round.
• Time value shrinks to zero at expiry, regardless of how much intrinsic value the option has — do not assume time value stays constant as expiry approaches.