An option's premium (the price you pay to buy it) is made of exactly two parts: intrinsic value, the built-in worth the option has right now, and time value, the extra you pay for the possibility that things improve before expiry.
What is intrinsic value?
Intrinsic value is what the option would be worth if it were settled this instant.
Say Kaveri Motors trades at ₹520 and Anjali is looking at the ₹500 call option, which is quoting a premium of ₹32. The right to buy at ₹500 something that sells at ₹520 is worth ₹20 straight away. That ₹20 is the intrinsic value.
- For a call: intrinsic value = market price − strike price (if positive, else zero).
- For a put: intrinsic value = strike price − market price (if positive, else zero).
Only in-the-money options have intrinsic value. At-the-money and out-of-the-money options have zero, if moneyness is fuzzy, see What are strike price, ITM, ATM and OTM?
What is time value?
Anjali's ₹500 call has ₹20 of intrinsic value but costs ₹32. The extra ₹12 is time value: the price of possibility. There are still two weeks to expiry, and Kaveri Motors could climb further, sellers charge for that chance.
Premium = intrinsic value + time value. In Anjali's case: ₹32 = ₹20 + ₹12.
An out-of-the-money option's premium is pure time value. If the ₹550 call quotes at ₹4 while the stock is at ₹520, all ₹4 is time value. The option has no built-in worth at all.
Two things mainly inflate time value:
- Time to expiry. More days means more chances for a big move, so longer-dated options cost more.
- Expected volatility. The more the market expects the underlying to swing, the more sellers charge. This expectation is captured by implied volatility. See What is implied volatility (IV)?
Why does the premium melt even when the stock doesn't move?
Time value is like an ice cube on a Chennai afternoon: it melts steadily, and faster towards the end. Every day that passes without a favourable move takes a slice off the time value. This is time decay (theta, in options jargon).
Suppose Anjali instead buys that ₹550 out-of-the-money call at ₹4 with two weeks left. If Kaveri Motors drifts sideways at ₹520, the option doesn't hold at ₹4. It bleeds to ₹3, ₹2, ₹1 as expiry nears, and settles at zero. The stock didn't fall; only the time ran out. Decay is slow when expiry is far away and accelerates sharply in the final days, which is exactly when many beginners buy cheap options hoping for a quick move.
At expiry, time value is always zero. Whatever intrinsic value remains is all the option is worth.
Time decay deserves — and has — its own article: What is time decay (theta)? covers how the melt accelerates, who it pays, and how to live with it.
Things to keep in mind
- Check how much of a premium is intrinsic and how much is time value before buying, with an OTM option you are paying entirely for possibility, and the odds are commonly against you.
- Time decay works against option buyers and for option sellers, every single day, weekends included.
- A rise in the underlying can still leave a call buyer flat or losing if time decay and falling volatility eat the gain. See What are the risks of trading Futures and Options (F&O)?
- All figures here are illustrative, not live quotes or predictions.
Read next
What is implied volatility (IV)? — The part of that premium reflecting expected movement rather than direction.