Quick Answer
Premium equals intrinsic value plus time value. Intrinsic value is the amount an option is in the money and can never be negative; time value is what's left of the premium and reflects the chance the option moves further in the money before expiration. Time value peaks at the money and hits zero at expiration.
Now that you know how options are created and traded, the next step is understanding what determines their price. Every options premium can be broken into two components: intrinsic value and time value.
What Makes Up an Option's Premium?
The fundamental equation for options pricing:
Premium = Intrinsic Value + Time Value
- The premium is the market price of the option, determined by supply and demand on the exchange
- Intrinsic value measures how much the option is worth if exercised right now
- Time value measures the extra amount buyers will pay for the possibility the option improves before expiration
How Do You Calculate Intrinsic Value?
Intrinsic value depends on the relationship between the stock's market price and the option's strike price:
| Option Type | In the Money When | Intrinsic Value Formula |
|---|---|---|
| Call | Market price above strike price | Market Price - Strike Price |
| Put | Market price below strike price | Strike Price - Market Price |
Key rules:
- Intrinsic value can never be negative. If the formula yields a negative number, intrinsic value is zero
- An option with intrinsic value is in the money (ITM)
- An option with no intrinsic value is out of the money (OTM) or at the money (ATM)
Example: Call Option
- XYZ 50 call when XYZ trades at $58
- Intrinsic value = $58 - $50 = $8
- This call is in the money by $8
Example: Put Option
- XYZ 50 put when XYZ trades at $43
- Intrinsic value = $50 - $43 = $7
- This put is in the money by $7
Example: Out-of-the-Money Option
- XYZ 50 call when XYZ trades at $45
- Formula: $45 - $50 = -$5, but intrinsic value cannot be negative
- Intrinsic value = $0
- This call is out of the money
Exam Tip: Gotchas
- Intrinsic value is never negative. If the formula gives a negative number, intrinsic value is zero. "No intrinsic value" does not mean "no value" since the option can still have time value.
How Does Time Value Behave?
- Time value = Premium - Intrinsic Value
- Time value reflects the probability that the option will move further into the money before expiration
- Time value is highest when the option is at the money (maximum uncertainty about whether it will finish ITM or OTM)
- Time value decreases as the option moves deeper in or out of the money
Time Decay (Theta)
- Time value erodes as expiration approaches; this erosion is called time decay or theta
- Time decay accelerates in the final weeks before expiration
- At expiration, time value is zero, so the option's premium equals its intrinsic value only
Example: Breaking Down a Premium
- XYZ 50 call trading at $11 when XYZ is at $58
- Intrinsic value = $58 - $50 = $8
- Time value = $11 - $8 = $3
- The buyer is paying $8 for the option's current in-the-money value, plus $3 for the chance it moves higher
Example: OTM Option Premium
- XYZ 50 call trading at $2 when XYZ is at $47
- Intrinsic value = $0 (out of the money)
- Time value = $2 - $0 = $2
- The entire premium is time value: the buyer is paying purely for the possibility the stock rises above $50
Exam Tip: Gotchas
- At expiration, time value is zero. The option's premium equals its intrinsic value only. If the option is out of the money at expiration, the premium is zero.
How Do You Read Moneyness at a Glance?
| Status | Call | Put |
|---|---|---|
| In the money (ITM) | Market price > Strike price | Market price < Strike price |
| At the money (ATM) | Market price = Strike price | Market price = Strike price |
| Out of the money (OTM) | Market price < Strike price | Market price > Strike price |
Memory Aid: Call Up, Put Down
A call is ITM when the stock goes up above the strike. A put is ITM when the stock goes down below the strike. Same shorthand also gives breakeven: call breakeven = strike + premium; put breakeven = strike - premium.
Remember: Calls and puts have opposite moneyness logic. A call is ITM when the stock is above the strike; a put is ITM when the stock is below the strike.
Exam Tip: Gotchas
- An OTM option still has a premium (entirely time value). For an OTM option with a premium, the intrinsic value is always zero and the entire premium is time value.
- Calls and puts have opposite moneyness logic. A call is in the money (ITM) when the stock is above the strike; a put is ITM when the stock is below the strike.
What Should You Check on Exam Day?
- Premium = intrinsic value + time value; intrinsic value is never negative
- Time value peaks at the money and equals zero at expiration (theta / time decay)
- An OTM option's entire premium is time value
- Calls are ITM above the strike; puts are ITM below the strike, the opposite logic