Options Values: Premium, Intrinsic Value, and Time Value

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. The exam tests this breakdown extensively.

Premium Components

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

Intrinsic Value

Intrinsic value depends on the relationship between the stock's market price and the option's strike 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.

Time Value

• 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.

Moneyness Summary

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). The exam frequently presents an OTM option with a premium and asks for the intrinsic and time value breakdown. The intrinsic value is always zero; 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.