4.1.6.1. Intrinsic Value and Time Value
The value of a premium is made up of two components: intrinsic value and time value.
premium = intrinsic value + time value
Intrinsic value is the per unit amount that the holder of an option stands to gain by exercising it. Stated another way, it is the extent to which the option is in the money. If the market price of a futures contract is $40 and the strike price of a call option is $30, the intrinsic value of the option is the difference: $10. If the market price is $20 with a $30 strike price, the option is out of the money and the intrinsic value of the option is zero.
For in the money call options: intrinsic value = market price – strike price
For out of the money call options: intrinsic value = $0
Remember that a put option is in the money when the price of the underlying contract is below the strike price. Using the same example, if the strike price of a put option is $30 and the current market price of the underlying contract is $20, the option is in the money and the intrinsic value is $10. If the contract is selling at $40, the intrinsic value of the put option is zero.
For in the money put options: intrinsic value = strike price – market price
For out of the money put options: intrinsic value = $0
Time value is the residual difference between the intrinsic value and th