Option Premiums and Understanding Time Value

There are two aspects involved in the price of an option, time value (extrinsic value) and cash value (intrinsic value). When you are buying an option a portion of the premium you pay is for time. It’s like putting money in a parking meter. The minute your money goes in, the clock starts ticking.

Understanding time value is the most important aspect of option trading. Just as you want to find the best location and closest parking spot and best-priced parking meter for you car, you want to find the best-priced option at the best strike price and time value for your trading purchase.

There are also three important positions an option strike price can occupy around a stock at given time “in the money”, “out of the money” and “at the money”. Only “in the money” options have intrinsic value.

Intrinsic value is the actual cash value in the option based on the price of the stock. An options intrinsic value, the amount an option is the is "in the money", is calculated by taking the difference between the strike price and the actual price of the underlying stock. For example, if a call option for 100 shares has a strike price of $25 and the stock is trading at $40 a share than the call option has an intrinsic value "in the money" value of $15 share, or $1500. If the stock price is less than the strike price the call option has no intrinsic value.

Time value, the amount of money we must feed into our parking meter, increases or decreases in relation to how far the strike price is from the underlying stock price. Deep “in the money” options and deep “out of the money” options have very little time value. Intrinsic value increases the further in the money an option moves. “At the money” options have a maximum amount of time value but no intrinsic value.

Intrinsic Value versus Time Value (Extrinsic)

The Relationship of Strike Price to Stock Price

Here is a simple example of an “in the money” option.

ABC Company is selling for $50.00 a share on January 15th. The $45.00 dollar strike “in the money” February call option is priced at $ 6.50.

$50.00 selling price - $45.00 strike price leaves us 5 dollars cash value (intrinsic).

$ 6.50 option price - $5.00 cash value = $1.50 time value. This represents the time value of the premium, or more simply the parking meter money we have to spend to hold this option to expiration.

Time is a wasting asset. Assume a purchase of an ABC company $45.00 Feb. call option for $6.50 when the stock price is $50.00. If ABC Company’s stock price did not change over the next 4 weeks and at expiration was exactly at $50.00, our option would be worth $5.00 when we exercise or liquidate the position. $ 1.50 was lost in time value.

Here is the same example of an “out of the money” option:

ABC Company is selling for $50.00 a share on January 15th. The $55.00 dollar strike in the money February call option is priced at $ 1.50.

$50.00 selling price - $55.00 strike price leaves us 0 dollars cash value.

$ 1.50 option price - $ 0 cash value = $1.50. This represents the time value of the premium, or simply the parking meter money we have to spend to hold this option to expiration.

Once again, time is a wasting asset. Assume a purchase of ABC Company $55.00 Feb. call option for $1.50 when the stock price is $50.00. If ABC Company’s stock price did not change over the next 4 weeks and at expiration was exactly at $50.00, our option would be worth $0.00 when we exercise or liquidate the position. $ 1.50 was lost in our parking meter.

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