Understanding Option Pricing: Intrinsic & Time Value

There are two primary factors that determine option costs: the time value and the intrinsic value. While not all options have intrinsic value (this applies only to in-the-money options), all options have time value. When the two factors are combined, you can determine the option’s net value.

Time Value

Recall that an option gives the owner the right, but not the obligation, to buy or sell a set quantity of a specific security at a specific price for a limited period of time. This right carries a certain value that decreases as the amount of time until the right disappears decreases. This is why time value of an option is often referred to as time decay; with each passing day that you own the option, the less your right to act on the stock becomes worth.

Intrinsic Value

The intrinsic value of an option defines how much the option would be worth if it were exercised immediately – in another sense, it defines how much profit has already been realized by the option as written. For example, if an option gives the owner the right to buy a stock that is trading at $35 for $30, there is $5 of intrinsic value in the option.