What it means
Intrinsic value is the straightforward half. For a call option it is the share price minus the strike price when that figure is positive, and zero otherwise, because an option can never be worth less than nothing.
Time value is everything else in the premium, and it reflects pure uncertainty. The longer until expiry and the more the underlying is expected to move around, the more a buyer will pay for the chance that the option finishes well in the money.
The premium is the number a finance team actually budgets for when using options as insurance. Hedging a fuel cost or an exchange rate is not free, and the premium is the cost of that cover in the same way an insurance premium is the cost of a policy.
Time value decays, slowly at first and then sharply in the final few weeks, until it reaches exactly zero at expiry. That is why short-dated options look cheap in absolute terms but are expensive measured by value lost per day.
Expected volatility is usually the biggest single driver of the premium, which is why options bought just before a results announcement look unusually costly. Once the announcement passes, expected volatility falls away and the premium can drop even when the share has moved in the buyer's favour.
In practice
Real-world examples.
Example
A treasurer prices currency options to cover $2,000,000 of euro payments and is quoted a premium of 1.4% of the covered amount, or $28,000. She presents it to the board as the cost of certainty, not as a trading position.
Example
An investor compares two call options on the same share, one expiring in a week at $1.20 and one in six months at $6.00. The longer contract costs five times as much because it carries far more time value, not because it is more likely to pay out per dollar spent.
Example
A trader sells covered call options on shares he already owns, collecting $2.50 a share in premium. If the shares stay below the strike price he keeps the entire premium, which is how the strategy generates income from a flat holding.
Think of it
“Premium is what you pay for the option-the price of having that right.
Formula
Calculation
Premium = intrinsic value + time value
Intrinsic value of a call = share price - strike price, or zero if that is negative
A share trades at $104, and a call option with a $100 strike and two months to expiry is quoted at $7.50 per share. Intrinsic value is $104 - $100 = $4.00, so time value is $7.50 - $4.00 = $3.50.
With a standard contract size of 100 shares, the buyer pays $7.50 x 100 = $750 in cash, of which $350 is time value that will erode to nothing by expiry if the share price stands still. To break even at expiry the share must reach $100 + $7.50 = $107.50.Case study
Seen in the real world.
Ashgrove Manufacturing is an invented company used as an illustrative example of premium as a budgeted cost. Facing a possible copper price spike, its board approved a hedging budget and bought call options covering 400,000 pounds of copper at a $4.00 strike, paying a premium of $0.25 a pound, a total of $100,000.
The finance director insisted on presenting the premium in the annual budget as an insurance line rather than burying it in cost of sales. When copper rose to $4.70, the options were worth $0.70 a pound, or $280,000, giving a net gain of $180,000 against the premium paid.
In the fictional following year copper drifted sideways, the options expired worthless, and the $100,000 premium was simply a cost. Because it had been budgeted as insurance from the start, nobody treated it as a trading loss, and the hedging policy survived a quiet year intact.
Watch out
Common mistakes.
- Reading the quoted premium as the total cash cost. Premiums are per share, so a $7.50 quote on a 100-share contract means $750 leaves the account.
- Assuming a cheap premium means a cheap option. Low-priced options are usually far from the strike price or close to expiry, so the odds of a payout are correspondingly low.
- Expecting the premium to rise whenever the share moves in your favour. A fall in expected volatility or the passage of time can outweigh a favourable price move.
Questions
People also ask.
Why does an option with no intrinsic value still cost money?
Because there is still time for the underlying to move, and buyers pay for that possibility as time value.
Does the seller ever have to return the premium?
No, the premium is kept in all cases, though the seller may face losses on the contract that far exceed it.
What makes premiums rise across a whole market?
Rising expected volatility, typically during periods of uncertainty, which lifts time value on almost every option at once.
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