Saturday, April 22, 2006

Option Basics --- Intrinsic Value and Time Value

The Components of Option Price

When we buy an option, we pay a price for the contract. This price is called “premium”.

This option price is consists of 2 price components, the intrinsic value and the time value.

The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option.

The time value is simply the difference between option value and intrinsic value. It is determined by the remaining lifespan of the option, the volatility and the cost of refinancing the underlying asset (interest rates) etc.

Time Value = Option Value - Intrinsic Value.

The time value will decrease with the time. Besides, the time value would also decrease when the underlying security price moves away from the strike price.

For better understanding of the option price, please see the following chart.

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