This page may help you in case that you don't fully understand the differences between an option's market price (premium), intrinsic value, and time value. It will show you how these three are related and how to easily calculate intrinsic and time value of an option, when you know the option's premium and the market price of the underlying stock. For an option trader these calculations should be subconscious and automatic.
In the money vs. out of the money options
There are two possible situations with options:
This property of options is called moneyness. It is closely related to intrinsic value.
While in the money options have positive intrinsic value, out of the money options have zero intrinsic value.
If you are missing at the money options in the above list, note that for the purpose of intrinsic value and our discussion below, they work the same as, and can be considered a border case of, out of the money options (because their intrinsic value is zero).
In the money call option example
Let's say we have a call option on Bank of America (BAC) stock with the strike price of 43 dollars and expiration date of 18 March 2022. On the options exchange this option is trading at 3.95 dollars. This is the option's market price, or the price for which you can buy or sell this option at the moment. Bank of America stock (the underlying) is trading at 44.50 in the stock market at the same time. What is the option's intrinsic and time value?
Calculating the option's intrinsic value
For a call option, intrinsic value is the amount you save on the underlying stock's purchase price when you exercise the option, compared to buying the stock in the stock market.
If you exercise this Bank of America call option, you will be buying Bank of America stock for 43 dollars (the strike price). On the other hand, if you buy Bank of America stock in the stock market, you pay 44.50. The call option's intrinsic value is the difference, equal to 1.50. The option is in the money, as its strike price is below the current market price of the underlying stock and you would be buying the stock cheaper with the option compared to buying the stock in the stock market.
Calculating the option's time value
What is the option's time value? We know that every option's market price has two components: intrinsic value and time value. Therefore you always have:
Option's market price = Intrinsic value + Time value
In our Bank of America call case, we know the option's market price (3.95) and we have just calculated the intrinsic value (1.50). It is easy to figure out the time value, which is 3.95 less 1.50 or equal to 2.45 dollars.
Out of the money call option example
Now we have another call option on Bank of America expiring in March 2022 (same underlying, same expiration), but this time the strike price is 48 and the option's market price is 1.70. The market price of Bank of America stock is 44.50 like in the previous example.
What is the intrinsic value? How much money would you save by exercising the option (buying the stock for 48) compared to buying the stock in the stock market (for 44.50)?
Answer: you save nothing, as the option's strike price is higher than the market price of the underlying stock. This call option is out of the money and its intrinsic value is zero. Intrinsic value can't be negative, because you don't have to exercise the option if it would lose money.
Now what is the time value? The market price of the option (1.70) has two components: intrinsic value (which is zero) and time value – which therefore must be 1.70.
Calculating intrinsic and time value of put options
There is only a little difference in these calculations for put options. Continue to the second part, which also contains a final summary, a note concerning at the money options, and an important final note about contract sizes: Put Option Price, Intrinsic, and Time Value.