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 of 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 its 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 |
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