Call Intrinsic Value = max(0, Stock Price − Strike Price) Put Intrinsic Value = max(0, Strike Price − Stock Price) Time Value = Option Premium − Intrinsic Value
The Short Version
An option's premium is made up of two parts. 'Intrinsic value' is the amount the option would be worth if exercised right now (how far 'in the money' it is). 'Time value' (or extrinsic value) is the extra amount buyers pay for the possibility that the option becomes more valuable before expiration. Time value shrinks as expiration approaches — a process called 'time decay'.
Explain It Like I'm 10
Imagine you have a coupon that lets you buy a $20 video game for only $15 — right now, that coupon is 'worth' $5 if you used it immediately, since you'd save $5. That guaranteed $5 savings is like 'intrinsic value.' But the coupon doesn't expire for another month, and the game might go on sale for more of a discount, or a cool new bonus pack might get added — so someone might pay you $7 for the coupon instead of just $5, because of that extra month of 'maybe it gets even better' possibility. That extra $2 is 'time value' — it's the price of hope and time, and it shrinks every single day as the coupon gets closer to expiring, because there's less time left for something good to happen.
Step-by-Step Example
- 1 A stock trades at $55. You own a call option with a $50 strike price.
- 2 Intrinsic value = Stock Price − Strike Price = $55 − $50 = $5 (what it'd be worth if exercised right now).
- 3 The option is actually trading for a $7 premium in the market.
- 4 Time value = Premium − Intrinsic Value = $7 − $5 = $2.
- 5 As expiration day gets closer, that $2 of time value slowly shrinks toward $0 — even if the stock price doesn't move at all — this daily shrinking is called 'time decay.'
- 6 On the very last day before expiration, the option's price will be almost entirely intrinsic value, with almost no time value left.
A call option with a $50 strike on a stock trading at $55, priced at a $7 premium, has $5 of intrinsic value and $2 of time value.
Quick Recap
- ✓ In the money (ITM): has intrinsic value (call: stock > strike; put: stock < strike).
- ✓ At the money (ATM): stock price ≈ strike price.
- ✓ Out of the money (OTM): no intrinsic value — the entire premium is time value.