Premium: intrinsic value and time value
Premium = intrinsic value + extrinsic (time) value. Only the intrinsic part survives to expiration.
Options risk. Long options can lose 100% of the premium; short options can lose far more and may be assigned early. Examples use synthetic prices and the common 100-share multiplier — check actual contract terms.
Splitting the premium
Call intrinsic = max(0, stock − strike). Put intrinsic = max(0, strike − stock). Extrinsic = premium − intrinsic.
Extrinsic value reflects time remaining, implied volatility and interest rates. It is largest near the money and decays toward zero at expiration. OTM options are 100% extrinsic.
Worked example
Decomposing two quotes (synthetic, stock at $48)
- 45-strike call at 4.20: intrinsic 48 − 45 = 3.00; time value 1.20.
- 45-strike put at 0.90: intrinsic 0 (OTM); time value 0.90.
- If the stock is still $48 at expiration: call worth 3.00 (−1.20 per share from decay), put worth 0.
When you buy an option, the extrinsic part is what you are paying for time and uncertainty.
Common misconceptions
“A cheap OTM option has limited downside so it's good value.”
Its entire price is time value, and the probability of it expiring worthless is high.
“Premium only depends on stock price.”
Time to expiration and implied volatility also drive it.
Checkpoint