Options contracts can be priced using mathematical models such as the Black-Scholes or Binomial pricing models.

An option’s price is primarily made up of two distinct parts: its intrinsic value and time value. Intrinsic value is a measure of an option’s profitability based on the strike price versus the stock’s price in the market. Time value is based on the underlying asset’s expected volatility and time until the option’s expiration.

Premium/Price = Intrinsic Value + Time Value

Intrinsic Value

Intrinsic Value = Premium - Time Value

The intrinsic value is the value of the option with no consideration for time. It is the value of the option at expiration. Therefore, it is the value of the option when there is no time. It is the REAL VALUE of an options contract. It reflects the amount, if any, by which an option is "in the money." The intrinsic value is usually the minimum value an option will have as an option will rarely trade below its intrinsic value.

To understand intrinsic value, think of having an accident insurance policy (a put) on your car. You paid a premium of $3,000 to insure your $50,000 auto for one year. If you were to sell your car within the year you could get a refund on part of the premium because you did not use all of the time. (The put would still have some time value in it.)

However, pretend on the day your policy expires, you total your car and you are unconscious for a week. When you wake up you find out that your car was totaled. Even though the policy expired a week earlier and there is no time value left in it, you are still covered. This is because the accident happened before the policy expired. Your policy expired with an intrinsic value of $50,000. You can still file a claim and receive the full difference between the face value of the policy and the current value of the car. 

In this example, you had a $50,000 policy and the auto was totaled. Therefore, you will receive $50,000. This is the policy’s (the put’s) intrinsic value and it does not go away even though the policy has expired.

If, at expiration, an option is in-the-money, that is, has intrinsic value, equal to or greater than one penny per share ($.01 in the money), then the Options Clearing Corporation (OCC) will automatically exercise that option on behalf of the option buyer. To determine the intrinsic value of an option, see the following example.

For example, to determine the intrinsic value of the $50 strike price call when XYZ stock is at $52, we would ask ourselves, "What is the right to buy XYZ for $50 worth, when its current market price is $52?"  It is worth $2. The right to buy the stock for $50 when the stock is at 52 saves us $2. With the 50 call, we could buy the stock for $50 and immediately sell it for $52 and make a profit of $2. Therefore, the 50 call has an intrinsic value of $2.

The right to buy the stock for $50 when its current market price is $49 would be worth nothing! Why pay for the right to buy at $50 when you can buy for $49.

Now, let’s determine the intrinsic value of the 50 put when XYZ is trading for $52.  "What is the right to sell XYZ at $50 worth, when its current market price is $52?"  Itis worth nothing. The stock is trading for $52, so why pay for the right to get only $50? However, if the stock was at $49, the $50 put would be worth at least $1 intrinsically and even more, if there was time some time value left. The intrinsic value of a call option equals the stock price less the strike price.

However, it can never have a negative value. An option either has value or not. The intrinsic value of the 55 put when the stock is trading at $57 is 0, not -2. Intrinsic value cannot go below 0. The 55 put with the stock at 57 would be $2 out-of-the-money. When the stock is at $53, the intrinsic value of the 55 put would be $2. The 55 put with the stock at $53 would be $2 in-the-money.

Time Value

Time Value = Premium - Intrinsic Value

The time value of an option is that portion of the option premium over and above its intrinsic value. Generally speaking, the more time before expiration and/or the more volatile the underlying stock, the higher the time premium will be. Such factors increase the probability of a stock reaching a certain price point. Thus, time value will be higher when the option is further from expiration and will decrease as the option gets closer to expiration.

A May option will cost more than an April option because there is more time for the stock to reach or go beyond the strike price. Out-of-the-money options carry only time value, if they have any value at all. Time value can be determined by subtracting the intrinsic value of an option from the premium.

If there is some time left before expiration an option may be worth more than its intrinsic value by an amount equal to its time value. An option that still has time value left prior to expiration will rarely be exercised, as it will bring the holder a greater value by simply selling it.

For example, let’s say XYZ stock is trading at 52 with a week left until expiration. The 50 call is trading at $2.50 because it has $2 of intrinsic value and $.50 of time value. If one were to exercise the call and buy the stock for 50 and then immediately sell the stock at 52, he would realize $2.00. However, if he simply sold the call, he would realize $2.50. Even if the call holder wanted to own the stock, he would be better off selling the call and then buying the stock. By doing so he would be able to buy the stock for fifty cents less per share. This is why an option that still has time value remaining is rarely exercised.

At expiration all the time value goes away and only intrinsic value remains. Time value usually diminishes as an option goes further ITM or OTM or, as it moves closer to expiration, to the point where it will eventually be reduced to nothing. If, prior to expiration, an option has intrinsic value (ITM) and there is little or no time value remaining, there is a high likelihood it could be exercised. Such an option is now trading at "parity."

An option is trading at parity with its stock if it is in-the-money and has no time value.

For example, if the 50 call was trading for $2 with the stock at 52 it would be trading at parity. If the option holder wanted to own the stock, he/she would exercise his option as there is no advantage in selling the call when there is no time value remaining. However, if he/she was merely speculating with the option and did not want to own the stock, he/she would still sell the option to avoid being automatically exercised and owning it.

Remember, if an optionexpires with intrinsic value equal to or greater than one penny per share ($.01) it will be automatically exercised by the Options Clearing Corporation (OCC). If a long call is exercised, the option holder will now have a long stock position. If he wants to avoid this, he will sell the put, even if there is no time value remaining.

Factors that Influence Time Value

The primary factors that influence time value are the length of time remaining until expiration, the underlying stock’s volatility, and an option’s supply and demand.

Time Decay

Just like the premium would be more to insure a car for two months than one month, so too, the time value of a May option will be more than an April. The time value is a wasting asset. Other factors being equal, the time value decreases as the option approaches expiration.

This decrease accelerates in a nonlinear fashion the closer the option gets to expiration as the following time graph illustrates.

This process is referred to as "time decay." At expiration only those options that are in-the-money will have any intrinsic value remaining (Remember intrinsic value does not change with time,) but no options will have any time value remaining. If the option is "out-of-the-money" and is not sold or exercised prior to its expiration, it will become worthless.

Time decay is advantageous to sellers of options and a disadvantage to buyers of options.

For example, the seller of a call option may, due to time decay, be able to buy back the option at a lower price than he originally sold it for, even if the stock does not drop in value. In such situations, the option seller can make a profit and eliminate the risk of being "assigned". If the option is well OTM, the seller may allow the option to expire worthless and keep the entire premium. When he sells an OTM option, an option seller is collecting money for time, as there is no intrinsic value. Should the stock at expiration be below the strike price, if it is a call, or above the strike price, if it is a put, the seller will retain the entire premium.