Option Premiums are Made of Only These Two Things

When trading options, it’s important to understand these two definitions.

It could mean the difference between making money and losing money.

Intrinsic Value

Everybody knows what intrinsic means in regular everyday life: real, innate, inherent, of within.

In options, the concept is the same.

The definition of intrinsic value as it pertains to options is: the difference between the underlying stock price and the option’s strike price (that’s in-the-money).

For example: if a stock was trading at $50, and a $45 call option with 30 days of time left on it was selling for $6.50, that option would have $5 of intrinsic value.

$50 stock price – $45 call option = $5. If the option premium is worth $6.50, that means $5 of that is intrinsic value.

The other $1.50 of that is extrinsic value, also known as time value.

Extrinsic Value (aka Time Value)

Extrinsic value is the amount of the premium that’s not comprised of intrinsic value. This part of the premium is said to be your ‘time value’. Out-of-the-money options are comprised of only time value.

Using the same example as above:

A $6.50 premium – $5 intrinsic value = $1.50 of extrinsic value.

So the key to remember is that options are comprised of two parts: intrinsic value and extrinsic value, i.e., time value.

So what’s the difference for the investor?

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— Zacks Investment Research

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