|
An option’s premium is made up of two value elements:
- intrinsic value
- time value
Intrinsic value is the inherent value of on option if it is exercised at any given point in time. Only options that are
in-the-money have intrinsic value. When you see moneyness phrases like “in-the-money”, “at-the-money” and “out-of-the-money”, the word “money” is referring to the option’s intrinsic value.
In addition to intrinsic value, all options have time value.
Time value is the difference between an option’s premium and an option’s intrinsic value. Time value is made up of many factors (volatility, interest rates, time to expiration, strike price) but is essentially the risk value attributed to an option as determined by the marketplace.
Time value erodes over time. It’s like an ice cube sitting under the sun. One thing is certain. As time goes by, time value will decrease. On the day an option expires time value dwindles to zero. At that moment, only intrinsic value is left standing.
|
