Derivatives and advanced market conceptsModule 1, lesson 6 of 21
Moneyness, intrinsic value and time value
In-the-money, at-the-money and out-of-the-money options, splitting a premium into intrinsic and time value, and why time value shrinks towards expiry.
In this lesson
- Classify calls and puts as in, at or out of the money.
- Split an option premium into intrinsic value and time value.
- Explain why time value shrinks towards expiry and reaches zero at expiry.
- Explain why an out-of-the-money option still has value before expiry.
Builds on
- Strike prices, premiums and expiryThis lesson breaks down the premium introduced there.
On this page
In simple terms
An option's premium has two parts:
- Intrinsic value: what the option would be worth if it were exercised right now.
- Time value: the extra amount buyers pay for the chance that the option becomes more valuable before it expires.
How much intrinsic value an option has depends on its moneyness: where the share price is compared with the strike.
In, at and out of the money
| Call | Put | |
|---|---|---|
| In the money (ITM) | Share price above strike | Share price below strike |
| At the money (ATM) | Share price near strike | Share price near strike |
| Out of the money (OTM) | Share price below strike | Share price above strike |
Intrinsic value
| Call intrinsic value | larger of (share price − strike) and 0 |
|---|---|
| Put intrinsic value | larger of (strike − share price) and 0 |
Intrinsic value is never negative, because the buyer would simply not exercise.
Splitting a premium
Worked example: Made-up calls on a share trading at ₹1,050
| Strike | Premium | Intrinsic value | Time value |
|---|---|---|---|
| ₹950 (ITM) | ₹118 | ₹100 | ₹18 |
| ₹1,000 (ITM) | ₹70 | ₹50 | ₹20 |
| ₹1,050 (ATM) | ₹32 | ₹0 | ₹32 |
| ₹1,100 (OTM) | ₹15 | ₹0 | ₹15 |
| ₹1,200 (OTM) | ₹3 | ₹0 | ₹3 |
Time value is usually largest at the money, where the outcome is most uncertain. Out-of-the-money options are all time value.
Time value shrinks towards expiry
As expiry approaches, there is less time for a favourable move, so time value falls. The fall is slow at first and speeds up near the end. At expiry, time value is zero and the option is worth only its intrinsic value.
Worked example: Time value of a made-up at-the-money option
| Days to expiry | Time value |
|---|---|
| 30 | ₹40 |
| 15 | ₹28 |
| 5 | ₹16 |
| 1 | ₹7 |
| 0 | ₹0 |
Half the time removes less than half the value at first; the last few days remove value quickly. The time decay lesson explains this in more detail.
This decay works against option buyers and for option sellers, every day, if nothing else changes.
Puts work the same way
Worked example: Made-up puts on the same share at ₹1,050
| Strike | Premium | Intrinsic value | Time value |
|---|---|---|---|
| ₹1,150 (ITM) | ₹112 | ₹100 | ₹12 |
| ₹1,050 (ATM) | ₹30 | ₹0 | ₹30 |
| ₹950 (OTM) | ₹8 | ₹0 | ₹8 |
For puts, the higher strikes are in the money, because the right to sell above the current price is worth something now.
Out of the money is not worthless, until expiry
Before expiry, an out-of-the-money option has a real price, because the share might still move past the strike. That price is entirely time value. At expiry, if it is still out of the money, it becomes worthless: the buyer loses the whole premium, as the calls and puts lesson shows.
Exercise or sell?
Before expiry, an option with time value is usually worth more sold in the market than exercised, because exercising captures only the intrinsic value and throws away the time value. This is one reason most options are closed by trading rather than exercised before expiry.
Why it matters
Splitting a premium shows what an option buyer is really paying for. Paying mostly for time value means paying for hope that steadily evaporates. Understanding moneyness and decay explains why so many options expire worthless and why buyers need not just the right direction but the right timing.
Limitations
The time values above are illustrative. Real time values also depend on volatility, interest rates and dividends, and change constantly with the market, as the volatility lesson explains.
Common mistakes
- Thinking an OTM option is "nearly free money" because it is cheap.
- Ignoring time value when buying options.
- Assuming decay is even across every day to expiry.
- Forgetting that at expiry only intrinsic value remains.
Try it yourself
- For a share at ₹500, classify calls and puts with strikes of ₹450, ₹500 and ₹550 as ITM, ATM or OTM.
- If those calls cost ₹58, ₹20 and ₹6, split each premium into intrinsic and time value.
- Work out what each call is worth at expiry if the share ends at ₹520.
Key takeaways
- A call is in the money when the share price is above the strike, and out of the money when it is below. For a put, it is the reverse. At the money means the price is near the strike.
- Intrinsic value is what an option would be worth if exercised now. It is never negative.
- Time value is the rest of the premium, the price of the chance that the option becomes more valuable before expiry.
- Time value shrinks as expiry approaches, faster near the end, and is zero at expiry.
- An out-of-the-money option has no intrinsic value but can still have time value, until expiry, when it becomes worthless.
Check your understanding
Try the numbers yourself
- Option payoff calculatorWhere does an option position make or lose money at expiry?
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Terms used in this lesson
- Moneyness
- Whether an option is in, at or out of the money, based on the underlying's price compared with the strike.
- Time value
- The part of an option's premium above its intrinsic value, paying for the chance of a favourable move before expiry.
- Option premium
- The price paid by an option buyer to the seller, quoted per unit of the underlying.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.