How it unfolds, step by step
The setup
On this chart, Index X sits at 20,040 and a call struck at 20,000 trades at ₹78. Forty of those rupees are intrinsic value, because the option is 40 points in the money. The other ₹38 is time value, paid for the fifteen sessions still to run.
What happens next
The index then does almost nothing. It drifts between 20,020 and 20,060 for a fortnight. Intrinsic value stays pinned near ₹40, because the level barely moves. Time value has no such support, and it erodes session after session.
What it means — and does not
By the final session the premium is ₹41. That is the intrinsic ₹40 the arithmetic guarantees, plus ₹1 of time value that is about to vanish. Nothing went wrong, and the option was never mispriced. The holder paid ₹38 for time, and time ran out. This is the single most common surprise in a first options account, and it is not a market view. It is subtraction. The same subtraction works at any level, and it is worth seeing at three. Take a call struck at ₹100 on an instrument, quoted on three separate occasions. With the instrument at ₹110 the call is ₹10 in the money. So a premium of ₹14 is ₹10 of intrinsic value and ₹4 of time value. With the instrument at ₹100 the call sits exactly on the strike, so intrinsic value is zero. A premium of ₹6 is then ₹6 of time value and nothing else. With the instrument at ₹94 the intrinsic value is still zero, because it never goes below zero. A premium of ₹2 is again entirely time value. Zero intrinsic value does not mean zero premium. It means every rupee of the premium is being paid for what might still happen.
- Option premium (₹)
- Intrinsic value · 40
With the underlying roughly flat, the premium falls from ₹78 to ₹41. The whole fall is time value. The dashed line is the intrinsic value the arithmetic keeps.
Show the underlying data
| Day | Option premium (₹) |
|---|---|
| 1 | 78 |
| 2 | 76 |
| 3 | 73 |
| 4 | 71 |
| 5 | 68 |
| 6 | 65 |
| 7 | 62 |
| 8 | 59 |
| 9 | 56 |
| 10 | 53 |
| 11 | 50 |
| 12 | 47 |
| 13 | 44 |
| 14 | 42 |
| 15 | 41 |
What this does not establish
The split is arithmetic, so it does not get 'invalidated' the way a chart reading does. The assumption behind holding one still does. The reading here is that intrinsic value is the durable part. That stops being true the moment the underlying crosses back through the strike. At that point intrinsic value becomes zero, and the whole premium is time value again. The strike is the reference level for this split. A position sized on the premium paid, rather than on the distance to the strike, has mistaken the two components for one.
Things to check
4How much of the premium is intrinsic value? Is the strike above or below the current level?
How many sessions remain for the time-value part to decay across?
Would the trade still make sense if the time value went to zero, which it will?
Remember: this is arithmetic on the example above. It is not a view on any instrument.
Common mistakes
2Reading a falling premium as the market disagreeing, when a flat underlying produces exactly the same fall.
Comparing two options by their premium alone. A cheap one can be entirely time value, and a dear one almost entirely intrinsic value.
- The market turned against the position during the fortnight
- The time-value part of the premium decayed, which it does whether or not the underlying moves
- The option was overpriced when it was bought
Show the answer
B. The time-value part of the premium decayed, which it does whether or not the underlying moves
A premium is intrinsic value plus time value. With the underlying flat, intrinsic value is unchanged and the entire fall is the time portion running out — which is what it is defined to do. Neither a market view nor a mispricing is needed to explain it.
Frequently asked
5How do I work out the intrinsic value of a call option?
The current level of the underlying minus the strike, or zero if that is negative. A call struck at 20,000 with the index at 20,040 has 40 points of intrinsic value. With the index at 19,900 it has none.
Why did my option lose money when the index did not fall?
Because the time-value part of the premium decays whether or not the underlying moves. On the example above, a flat fortnight costs ₹37 of a ₹78 premium.
Is time value the same as implied volatility?
No, but they move together. Implied volatility is the market's assumption about how much the underlying will move. A higher assumption produces more time value in the premium for the same time remaining.
Can an option with no intrinsic value still have a price?
Yes, and most of them do. Intrinsic value is never negative. For a call it is the level minus the strike, or zero if that would be a negative number. A call below its strike has none at all. What is left is time value: what somebody will pay for the chance that the level moves before expiry. On the call struck at ₹100 above, a premium of ₹2 with the instrument at ₹94 is ₹2 of time value and nothing else.
How do I split a premium I can see on a screen?
Subtract the intrinsic value from the premium, and what remains is time value. Two cautions keep the answer honest. First, read the underlying and the option at the same moment. A stale option price against a fresh level produces a leftover that is really a timing error. Second, note whether the premium is a last traded price, a bid, an offer or a midpoint. Those are four different numbers, and only one of them is what a seller would be paid.