Intrinsic Value vs. Time Value

Every option premium consists of two components: intrinsic value and time value (also called extrinsic value). Understanding this breakdown helps traders evaluate whether an option is fairly priced and anticipate how the premium will change over time.

Definition and Key Concepts

Intrinsic Value

Intrinsic value represents the amount by which an option is in-the-money. It is the value the option would have if exercised immediately.

For a call option: Intrinsic Value = Max(0, Stock Price - Strike Price)

For a put option: Intrinsic Value = Max(0, Strike Price - Stock Price)

An option cannot have negative intrinsic value. When an option is out-of-the-money or at-the-money, its intrinsic value is zero.

Time Value

Time value (extrinsic value) is the portion of the premium that exceeds intrinsic value. It represents the market's assessment of the probability that the option could become more valuable before expiration.

Time Value = Option Premium - Intrinsic Value

Time value is influenced by:

• Time remaining until expiration
• Implied volatility of the underlying
• Distance from the strike price to the current price
• Interest rates (minor effect)
• Dividends expected before expiration

The Complete Premium

How It Works in Practice

Time Value Decay

Time value erodes as expiration approaches—a process called time decay or theta decay. At-the-money options have the highest time value in dollar terms, while deep in-the-money and deep out-of-the-money options have less time value.

Time decay accelerates as expiration nears. An option with 90 days to expiration might lose $0.02 per day in time value, while the same option with 7 days left might lose $0.15 per day.

Moneyness and Value Components

Impact on Trading Decisions

Option buyers pay for time value that will eventually decay to zero. If the underlying doesn't move enough to offset time decay, the trade loses money even if the direction was correct.

Option sellers collect time value and profit as it decays. However, they face unlimited risk (uncovered calls) or substantial risk (uncovered puts) if the underlying moves sharply against them.

Worked Example

XYZ stock trades at $52. Consider these options with 30 days to expiration:

$50 Call (In-the-Money)

• Premium: $4.20
• Intrinsic Value: $52 - $50 = $2.00
• Time Value: $4.20 - $2.00 = $2.20
• Delta: 0.65

$52.50 Call (Near ATM)

• Premium: $2.30
• Intrinsic Value: $0 (stock below strike)
• Time Value: $2.30
• Delta: 0.48

$55 Call (Out-of-the-Money)

• Premium: $0.85
• Intrinsic Value: $0
• Time Value: $0.85
• Delta: 0.28

15 Days Later (XYZ still at $52):

All three options lost value from time decay alone, despite no change in the stock price. The ATM option lost the most in absolute terms because it had the highest time value.

Risks, Limitations, and Tradeoffs

Time Value Risk for Buyers

Option buyers face the certainty that time value will decline to zero by expiration. Even a correct directional view may not produce profits if the move doesn't occur quickly enough or isn't large enough to overcome time decay.

Limited Upside for Deep ITM Options

Deep ITM options behave more like stock ownership but cost more than ATM or OTM options. The limited time value means less leverage, but also less time decay risk. Traders pay primarily for intrinsic value, which doesn't decay.

Volatility's Effect on Time Value

Time value increases when implied volatility rises. This benefits option buyers who own contracts before a volatility spike. Conversely, declining volatility crushes time value even when time to expiration hasn't changed significantly.

Common Pitfalls

1. Overpaying for time value: Buying OTM options with high implied volatility means paying elevated time value that may quickly erode.

2. Ignoring time decay rate: Time decay is not linear. The final two weeks before expiration see accelerated decay, particularly for ATM options.

3. Confusing premium with value: A cheap option (low premium) is not necessarily a good value if the time value is disproportionate to the probability of profit.

4. Holding through expiration: Many traders hold losing options hoping for recovery, only to lose 100% of time value at expiration.

5. Misunderstanding early exercise: Deep ITM American options sometimes trade below intrinsic value due to carrying costs, but the market typically prices them at or above intrinsic value.

Checklist for Evaluating Option Value

• Calculate intrinsic value using current stock price and strike price
• Subtract intrinsic value from premium to find time value
• Compare time value to days remaining until expiration
• Check implied volatility versus historical averages
• Estimate daily time decay (theta) and multiply by holding period
• Determine if the expected price move justifies the time value paid
• Consider whether selling premium (collecting time value) might be appropriate

Next Steps

Understanding intrinsic and time value prepares you to evaluate exercise decisions. American-style options can be exercised early, which becomes relevant when time value is minimal. Learn more in American vs. European Exercise Rights.

For a review of how strikes and expirations affect these values, see Option Contract Specifications: Strike, Expiry, Style.