Intrinsic value and time value
An option's price is two things added together. One of them melts away a little every day.
Take any option premium and split it in two.
- Intrinsic value. What it would be worth if it expired this instant. For an out-of-the-money option this is zero — never negative.
- Time value. Everything else. What people will pay for the chance that things improve before expiry.
Share at $100, call with a $90 strike, premium $13. Intrinsic value is $10, because the right to buy at $90 when the price is $100 is worth $10. The remaining $3 is time value — paid for the possibility that the share climbs further before expiry.
Time value goes one way
Every day that passes, there is less time left for things to improve. So time value shrinks, and at expiry it is exactly zero. An option at expiry is worth its intrinsic value and nothing more.
This is called time decay, and it is the most important fact about holding options.
Time value does not drain evenly. An option loses a small fraction of it in a distant month and a large fraction in its final weeks. The last few days are brutal for a holder and correspondingly kind to a writer.
What this means for a buyer
You are fighting a clock that never stops. If the share does nothing at all, you lose money every day — not because you were wrong, but because time passed.
It is the reverse of owning a share. A share owner who is wrong about timing simply waits. An option buyer who is wrong about timing loses the position.
What it means for a writer
The person who sold you the option collects that decay. Every uneventful day transfers a little value from the buyer to the writer. That is the writer's entire business model, and it works until it spectacularly does not — which is the subject of the next lesson.