🎯 In 30 seconds: An option's price has two parts. Intrinsic value is what it would be worth if exercised right now. Extrinsic value, mostly time value, is everything else: the price of the chance that things get better before expiration. Time value shrinks every day and reaches zero at expiration, and it shrinks fastest in the last few weeks. That is why buyers fight the clock, sellers collect from it, and short-dated out-of-the-money options usually expire worth nothing.
Two parts of every option price
Option price (premium) = intrinsic value + extrinsic value.
Intrinsic value is the amount an option is in the money. It can never be negative.
| Call intrinsic value | max(stock price - strike, 0) |
| Put intrinsic value | max(strike - stock price, 0) |
| Extrinsic (time) value | option price - intrinsic value |
Extrinsic value is the extra amount buyers pay above intrinsic value. It comes mainly from time left and expected volatility: the more time and the bigger the expected swings, the better the chance the option ends up worth more. People often call it "time value", and this chapter does too.
You will need the basics from What an option is, Call options and Put options.
In, at and out of the money
Moneyness describes where the stock is relative to the strike.
| Call | Put | |
|---|---|---|
| In the money (ITM) | stock above strike | stock below strike |
| At the money (ATM) | stock about equal to strike | stock about equal to strike |
| Out of the money (OTM) | stock below strike | stock above strike |
Only ITM options have intrinsic value. ATM and OTM options are made entirely of time value.
Worked example: splitting five prices
Hypothetical. Company X at $50, 60 days to expiration, prices from a standard pricing model at 30% volatility.
| Option | Moneyness | Price | Intrinsic | Time value | Per contract (time value) |
|---|---|---|---|---|---|
| $45 call | ITM by $5 | $5.85 | $5.00 | $0.85 | $85 |
| $50 call | ATM | $2.58 | $0 | $2.58 | $258 |
| $55 call | OTM by $5 | $0.86 | $0 | $0.86 | $86 |
| $45 put | OTM by $5 | $0.56 | $0 | $0.56 | $56 |
| $55 put | ITM by $5 | $5.50 | $5.00 | $0.50 | $50 |
Two lessons sit in this table.
- ATM options carry the most time value. The $50 call is all time value, $2.58. The $45 and $55 options, $5 away from the stock on either side, carry much less.
- Time value is the part you are betting with. If you buy the $50 call and the stock is still $50 at expiration, all $258 is gone. If you buy the $45 call, only $85 of your $585 is at risk from time alone. The rest is intrinsic value, which moves with the stock.
What makes time value bigger or smaller
- Time to expiration: more time, more time value.
- Volatility: the more the market expects the stock to swing, the more an option is worth. This is measured by implied volatility, covered in Implied volatility.
- Distance from the strike: time value peaks at the money and fades in both directions.
- Interest rates and dividends: smaller effects. Higher rates nudge calls up and puts down. An expected dividend nudges calls down and puts up. How options are priced covers the full model.
Time decay speeds up at the end
Time decay is the loss of time value as expiration approaches, with everything else unchanged. It is measured by the Greek theta, explained in The Greeks.
Decay is not a straight line. For an at-the-money option it is slow when expiration is far away and fast near the end.
From the same model, the $50 call with the stock pinned at $50:
| 90 days left | $3.21 |
| 60 days left | $2.58 |
| 30 days left | $1.80 |
| 14 days left | $1.21 |
| 7 days left | $0.85 |
| 1 day left | $0.32 |
| Expiration | $0 |
From 90 to 60 days, the call loses $0.63, about 2 cents a day. In the final 7 days it loses $0.85, about 12 cents a day. Same stock price, six times the daily bleed.
A rough rule from the math behind option pricing: time value of an ATM option scales with the square root of time left. Cut the time by four and the time value roughly halves. That is why 30 days of option costs much more than half of 60 days: here $1.80 versus $2.58.
Why most short-dated OTM options expire worthless
An OTM option has no intrinsic value. To be worth anything at expiration, the stock has to travel past the strike before time runs out. With little time, that is a long trip.
A pricing model can estimate the chance of finishing in the money. These estimates come from the same model and assumptions as the prices, at 30% volatility with Company X at $50. They are not forecasts, but they show the shape of the problem.
| Call | Days left | Price | Per contract | Model chance of finishing ITM |
|---|---|---|---|---|
| $52.50 (5% OTM) | 30 | $0.83 | $83 | about 28% |
| $52.50 (5% OTM) | 7 | $0.13 | $13 | about 12% |
| $55 (10% OTM) | 30 | $0.33 | $33 | about 13% |
| $55 (10% OTM) | 7 | $0.01 | $1 | about 1% |
A $13 call feels like a cheap lottery ticket. In this model it finishes in the money about one time in eight, and finishing in the money is still not enough. To profit, the stock must clear strike + premium, $52.63, which is even less likely. Most of these tickets go to zero, and that is exactly what the low price tells you.
It does not mean option buyers always lose or sellers always win. Sellers of cheap OTM options collect small amounts most of the time and occasionally take a loss many times larger. Both sides are paid roughly what the odds suggest, minus the spread and fees.
Value before expiration vs at expiration
Payoff diagrams in earlier chapters show value at expiration, when only intrinsic value is left. Before expiration, an option is worth more than its intrinsic value because of the time value on top. That is the blue curve sitting above the green hockey stick in the first figure.
It also explains why exercising early usually wastes money. Exercising a call captures only intrinsic value. Selling it in the market captures intrinsic plus time value. The exceptions, mainly around dividends, are covered in Exercise, assignment and expiration.
Try it
Open an options chain for a stock on your Watchlist. Pick the nearest monthly expiration and one about 90 days out. For the ATM call, one call 5% ITM and one call 5% OTM in each expiration, compute intrinsic value and time value using the midpoint of bid and ask. Then check the same six options again in one week and calculate how much time value each lost per day. You should see the ATM option in the near expiration losing the most per day.
- What are the two parts of every option price? Answer: Intrinsic value (how much it is in the money) and extrinsic value, mostly time value (everything else).
- Company X is at $50. A $45 call costs $5.85. How much is intrinsic value and how much is time value? Answer: Intrinsic value is $5.00 and time value is $0.85.
- Which options carry the most time value: in, at or out of the money? Answer: At-the-money options. Time value peaks at the strike and fades in both directions.
- With the stock pinned at $50, how fast does the $50 call lose value from 90 to 60 days, and in the final 7 days? Answer: About 2 cents a day from 90 to 60 days ($0.63 in total), and about 12 cents a day in the final 7 days ($0.85). Decay speeds up at the end.