The split
Option premium = intrinsic value + time value. Always. There is no third component and no exception.
The two parts behave nothing alike, which is why lumping them together as "the price" makes options feel unpredictable. Separate them and most of the strangeness disappears.
Intrinsic value is arithmetic
For a call: the underlying price minus the strike, or zero, whichever is larger. For a put: the strike minus the underlying, or zero.
That is it. A 100 call with the underlying at 106 has 6 of intrinsic value. There is no judgement involved, nothing to forecast, and no way for the market to disagree — if it traded below 6, you could buy the option, exercise it and pocket the difference.
Intrinsic value is the floor. It cannot go negative, which is the whole reason an option's downside is capped.
Time value is opinion
Everything above intrinsic is time value, and it is pure market opinion about what might happen before expiry. Three things feed it: how long is left, how much the underlying moves around, and how much people currently want options.
Two properties matter more than all the rest:
- It goes to zero. Not probably — certainly, on a known date. Every rupee of time value in an option you hold is a rupee scheduled for deletion.
- It peaks at the strike. Time value is largest when the outcome is most uncertain, which is when the underlying sits right at the strike. Move far in either direction and the outcome becomes obvious, so there is less uncertainty left to pay for.
Buying an option means buying a certainty and a possibility in one transaction, then hoping the possibility outruns the certainty.
How the mix changes with moneyness
| Position | Intrinsic | Time value |
|---|---|---|
| Out of the money | Zero | All of it |
| At the money | Zero or near it | All of it, and at its maximum |
| Deep in the money | Nearly all of it | Very little |
Read that table again with the previous section in mind and something important falls out. A cheap out-of-the-money option is 100% the part that expires worthless. It is not a small bet on the same thing as a deep in-the-money option — it is a different instrument, holding nothing but the perishable component.
Judging an option as expensive or cheap by its premium in rupees. A ₹4 option that is entirely time value and a ₹40 option that is 36 intrinsic are not comparable numbers. Split every premium into its two parts before deciding anything — it takes five seconds and it is the difference between knowing what you bought and guessing.
Read it yourself
Strike 100. Work each one out before revealing.
The chart above is expiry day for a 100 call.
- The underlying is at 107 and the 100 call trades at 9.2. Split the premium.
- The underlying is at 94 and the 100 call trades at 1.6. Split it.
- On the chart above, what is the 100 call worth at the final close, and how much did a holder lose to time value that day?
Show answers
1. Intrinsic 7, time value 2.2. You are paying 2.2 for the chance it goes higher, and that 2.2 is on a schedule to disappear.
2. Intrinsic zero, time value 1.6. The entire premium is the perishable part. The underlying must climb more than 6 just to reach the strike, and more than 7.6 for you to break even.
3. The final close is 99.4 — below the strike. The call is worth nothing. Whatever time value it carried at the open is gone in full, and note how undramatic the chart is: the underlying drifted two rupees across the whole session. No crash, no news. The option expired worthless because time value always does.
Terms used
- Premium
- The traded price of the option. Intrinsic plus time value.
- Intrinsic value
- What the option would be worth if expiry were now. Never negative.
- Time value
- Everything above intrinsic. Goes to zero at expiry.
- In the money
- The option has intrinsic value.
- Out of the money
- It does not. The premium is entirely time value.