As a financial derivative, the value of an option consists of two parts, i.e. intrinsic value and time value, which together determine the total value of the option, and will be described in detail below.
Before the introduction, there are three basic concepts that need to be briefly understood, i.e. In the money, Out of the money and At the money.
ITM,OTM,ATM
A call option is said to be "In the money" when the price of the underlying asset is above the strike price. A call option is "out-of-the-money" when the underlying asset price is below the strike price. For a put option, the option is said to be "In the money" when the underlying asset price is below the strike price, and "Out of the money" when the underlying asset price is above the strike price. The term "at-the-money" means that the underlying asset price is closest to the Exercise price of the option. When this occurs, both the call and put options will be "at-the-money" at the same time.
Intrinsic Value
Definition: Intrinsic value is the value of the option if it were to expire at this time.
When an option is in the money, it is said to have "intrinsic value", while if it is out-of-the-money, it is said to have no "intrinsic value". When an option expires out-of-the-money, it is said to be "worthless at expiration".
Call Option: Intrinsic Value = Underlying Asset Price - Strike Price
Put Option: Intrinsic Value = Strike Price - Underlying Asset Price
Time Value
Definition: The additional return that an option may earn prior to expiration due to market volatility, interest rates and other factors.
Time Value = Option Price - Intrinsic Value
Time value decreases as the expiration date approaches until it reaches 0. When the option expires, the time value is 0, at which point the option value equals the intrinsic value.
