Split an option's price into time value and intrinsic value
The idea
An option's price is the sum of intrinsic value — what exercising now would yield, floored at zero — and time value, the additional amount buyers pay for the chance of a favourable move before expiry. Time value is greatest when the option is at the money, because that is where uncertainty about the final outcome is highest, and it decays toward zero as expiry approaches. The decay is not linear: it accelerates in the final weeks, which is why time value is described as wasting rather than amortising evenly.
Formulas
Intrinsic value and time value
option price = intrinsic value + time value
- intrinsic value
- what the option would pay if it expired now, never below zero
- time value
- everything else in the price — what the remaining time might yet do
Time value falls to zero at expiry, and does so faster as expiry nears. An out-of-the-money option has no intrinsic value and still has a price, which is entirely time value.
A practice question
What is the intrinsic value of a call with an exercise price of 30 when the underlying trades at 26?
- Zero — correct
- Minus 4Why not: Intrinsic value is floored at zero; the holder simply declines to exercise rather than realising a negative amount.
- 4Why not: The gap is in the wrong direction: the underlying is below the strike, so exercising would cost four rather than gain it.
Intrinsic value cannot be negative: the holder would not exercise. The option still has a positive price made up entirely of time value.
A harder one
A call with a strike of 60 trades at 7 while the underlying is at 63. What is its time value?
- 7Why not: The whole premium, which is intrinsic value and time value together.
- 3Why not: The intrinsic value, 63 less 60. Time value is what remains of the premium after that.
- 4 — correct
Intrinsic value is three, so the remaining four is what buyers are paying for the time left.
The hardest tier
Why does time value decay accelerate as expiry approaches?
- Because exchanges reduce the quoted price near expiryWhy not: Exchanges match orders and do not set prices; the decay is a property of the option itself.
- Because the remaining window shrinks — correct
- Because volatility is contractually reset at expiryWhy not: Nothing is reset. What shrinks is the window over which the volatility can act.
With it goes the dispersion of possible outcomes. The value of optionality scales with the uncertainty still to be resolved, which falls roughly with the square root of remaining time, and that is why the last weeks lose far more value than earlier ones of the same length.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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