The value of options contracts are based on the market price of the underlying stock.  What’s more, option contracts exist for only a few brief months so what value they borrow from the stocks they represent is fleeting.  Due to these characteristics and the fact that a contract can go from worthless (out of the money) to profitable (in the money) with a price swing of only a few pennies it’s important to understand the factors that work together to give an option value as you’re trying to wrest profit from them.

Intrinsic Value
Unlike intrinsic value for the underlying stock itself which represents value that is tangible and acts as a floor below which the stock price is very unlikely to fall, intrinsic value for an option contract is a temporary measure of how profitable the contract would be if exercised immediately.

If, for example, if the strike price of a call option was four dollars below the current market price of the stock it would have an intrinsic value of four points.  The same is true for a put option with a strike price of four dollars above the current market price.  Both contracts, if immediately exercised, would profit four dollars per share of the contract or $400.

Time Value
Option contracts that are out of the money have no intrinsic value.  Yet, they still trade for a premium on the open market.  This premium represents the potential that the option will eventually be in the money and is based both on the difference between strike price and current share price and how long the contract has until expiration.

The value imparted by the difference between market price and strike price is obvious.  The closer a stock’s price is to the strike price the higher the probability that the price will rise or fall enough to pass the strike price and push the contract into profitability.

But, how much this price difference impacts the premium charged for the contract depends on how much time the option has before it expires.  An option contract that’s two points out of the money has much more value if contract expiration is thirty days away vs. three days away because those extra twenty-seven days give much more time for stock price movements that could potentially build intrinsic value.

So, option valuation is a combination of intrinsic value which represents the actual profitability of the contract if it were exercised today and time value which represents the potential that the contract has to build intrinsic value before it expires.  Because this potential decreases as time goes on, time value also decreases until, at option expiration, the time value is zero.