Intrinsic and time value

An option's premium is not one number but two summed: what it would be worth exercised right now, and what its remaining possibility is worth. Separating them is the key to why options move as they do.

Intrinsic value

Intrinsic value is what the option is worth if exercised immediately: for a call, the underlying minus the strike when the underlying is higher (a 50 call with the underlying at 53 is worth 3 exercised); for a put, the strike minus the underlying when the underlying is lower. It cannot be negative - if exercising would lose money, the holder simply does not, and intrinsic value is zero. Intrinsic value tracks the underlying directly: it is the part of the option that behaves like the share position it references.

Time value

Time value is the rest of the premium - the amount above intrinsic value that buyers pay for the possibility the option becomes more valuable before expiry. If the 50 call at 53 has a premium of 5, then 3 is intrinsic and the remaining 2 is time value: payment for the chance the underlying rises further before the option expires. Time value is largest when that chance is greatest - plenty of time left, high volatility - and it is the part of the premium that has no equivalent in a share, the part that makes options their own instrument.

Why the split governs behaviour

• The two parts move differently: intrinsic value tracks the underlying one-for-one; time value responds to time passing and volatility changing, on its own logic.
• Time value decays: it erodes toward zero as expiry approaches (lesson 5), a force that works against every option buyer and for every seller - the option's built-in clock.
• At expiry, only intrinsic remains: time value is zero at expiry, so an option is worth exactly its intrinsic value at the end - the resolution lesson 7 examines.

Every later options concept refers to this split: time decay is the erosion of time value, volatility's effect is mostly on time value, and moneyness (lesson 8) is a statement about how much of the premium is intrinsic. Splitting the premium into its two parts is the analytical move that makes options legible - and it is why an option and a share, though one references the other, behave nothing alike.