Option Premiums: Intrinsic Value & Time Value
An option’s price is two things stitched together: what it’s worth right now, plus what it might become before it expires — and that second part melts away.
Last lesson raised a puzzle: an out-of-the-money option (say a call struck at $60 when the stock is $50) would be worthless if exercised today — yet people pay real money for it. Why would anyone pay for a right that’s currently useless? And here’s a stranger fact: two identical options, same strike, can trade at very different prices — and an option quietly loses value every single day even if the stock doesn’t move. Both mysteries dissolve once you see that an option’s price is made of two ingredients. Hold the question: what are you actually paying for when you buy an option that’s worthless right now?
Two ingredients: intrinsic value + time value
An option’s price (its premium, from lesson 16) splits cleanly into two parts. Intrinsic value is what the option is worth if exercised right now — the in-the-money amount from last lesson (a call struck at $40 with the stock at $50 has $10 of intrinsic value; an out-of-the-money option has zero intrinsic value). Time value is everything else you’re paying — the extra for the possibility that the price moves further in your favor before the option expires. So: premium = intrinsic value + time value. That’s why an out-of-the-money option still costs something: its intrinsic value is zero, but you’re buying its time value — the chance it swings into the money before it’s done.
Time value decays — and hits zero at expiry
Here’s the “loses value every day” mystery solved. Time value exists because there’s still time for a favorable move — so as the expiration date approaches, there’s less time left for that move, and time value shrinks. This is time decay: an option, all else equal, is worth a little less each day purely because it has less life remaining. And at the moment of expiry, there’s no time left at all, so time value is exactly zero — an option is worth only its intrinsic value at the end. An out-of-the-money option therefore decays all the way to nothing if the price never crosses the strike. This connects to the time value of money (lesson 6) in spirit: time itself is worth something here, and it’s a wasting asset — the clock is always running against the option holder.
A call struck at $50, stock at $53, premium $5: • Intrinsic value = $3 (you could buy at $50 something worth $53). • Time value = $5 − $3 = $2 (the extra you’re paying for possible further upside before expiry). • As expiry nears with the stock still ~$53, that $2 of time value melts toward $0, so the premium drifts down toward its $3 intrinsic value — even though the stock didn’t move.
Why volatility makes options cost more
One more deep piece that surprises people. More volatility (bigger expected swings, lesson 33) makes an option more expensive — higher time value. Why? Because of the option’s asymmetry (lesson 36): a bigger swing up means a bigger payoff on a call, while a bigger swing down just means you don’t exercise — your loss is still capped at the premium. When the downside is capped but the upside grows with the size of the move, more wildness is pure upside for the option holder, so they’ll pay more for it. This is the counterintuitive heart of options: the same volatility that terrifies a stock holder is valuable to an option holder, and it’s a big part of why option prices move even when the stock sits still. (Education on how the pricing works — emphatically not advice to trade options.)
Think of a “buy this house for $300k” voucher that expires in a year. If the house is already worth $320k, the voucher has $20k of obvious, cash-in-now worth (intrinsic value). But even if the house is only worth $290k today, the voucher isn’t worthless — there’s a year for the market to rise past $300k, and that hope has a price (time value). As the year runs down, that hope shrinks — a voucher with one week left is worth far less than one with eleven months — and on the final day it’s worth only its cash-in-now value, nothing more. And if the neighborhood is famously volatile (prices swing wildly), the voucher is worth more, because a big upswing pays off while a big downswing costs you nothing beyond the voucher.
Watching the two ingredients move: 1. Deep in-the-money call (stock $80, strike $50): premium ~$31 — mostly intrinsic value ($30), little time value. It behaves almost like the stock. 2. Out-of-the-money call (stock $50, strike $60): premium ~$2 — all time value, zero intrinsic. A pure bet on a move before expiry. 3. Same option a month later, stock unchanged: the time-value portion has shrunk (time decay), so the premium fell even with no price move. 4. News makes the stock much more volatile: time value (and premium) rises, because bigger swings help the capped-downside option holder.
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