July 14th, 2016 by jja_fr

Fundamentally, an option premium reflects two components: “intrinsic value” and “time value.” A number of mathematical models are employed to identify the fair value of an option notably including the Black-Scholes model.

Premium = Intrinsic Value + Time Value

The purpose of this section, however, is not to describe these models but to introduce some of the fundamental variables which impact upon an option premium and their effect.

### Intrinsic Value

The intrinsic value of an option is equal to its in-the-money amount. If the option is out-of-the-money, it has no intrinsic or in-the-money value. The intrinsic value is equivalent, and may be explained, by reference to the option’s “terminal value.” The terminal value of an option is the price the option would command just as it is about to expire.

When an option is about to expire, an option holder has two alternatives available to him. On one hand, the holder may elect to exercise the option or, on the other hand, may allow it to expire unexercised.

When an option is about to expire, it is either in-the-money and exercisable for a value reflected in the difference between market and strike price or, it is at- or out-of-the-money and has zero intrinsic value.

As such, the issue revolves entirely on whether the option lies in-the-money or out-of-the-money as expiration draws near. If the option is out-of-the-money then, of course, it will be unprofitable to exercise and the holder will allow it to expire unexercised or “abandon” the option. An abandoned option is worthless and, therefore, the terminal value of an out-of-the-money option is zero. If the option is in-the-money, the holder will profit upon exercise by the in-the-money amount and, therefore, the terminal value of an in-the-money option equals the in-the-money amount.

### Time Value

An option contract often trades at a level in excess of its intrinsic value. This excess is referred to as the option’s “time value” or sometimes as its “extrinsic value.” When an option is about to expire, its premium is reflective solely of intrinsic value. But when there is some time until option expiration, there exists some probability that market conditions will change such that the option may become profitable (or more profitable) to exercise. Thus, time value reflects the probability of a favorable development in terms of prevailing market conditions, which might permit a profitable exercise.

Generally, an option’s time value will be greatest when the option is at-the-money. In order to understand this point, consider options that are deep in- or out-of-the-money. When an option is deep out-of-the-money, the probability that the option will ever trade in-the-money becomes remote. Thus, the option’s time value becomes negligible or even zero.

An option’s extrinsic value is most often referred to as time value for the simple reason that the term until option expiration has perhaps the most significant and dramatic effect upon the option premium. All other things being equal, premiums will always diminish over time until option expiration.

In order to understand this phenomenon, consider that options perform two basic functions – (i) they permit commercial interests to hedge or offset the risk of adverse price movement; and (ii) they permit traders to speculate on anticipated price movements. The first function suggests that options represent a form of price insurance. The longer the term of any insurance policy, the more it costs. The longer the life of an option, the greater the probability that adverse events will occur … hence, the value of this insurance is greater. Likewise, when there is more time left until expiration, there is more time during which the option could potentially move in-the-money. Therefore, speculators will pay more for an option with a longer life.

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