Intrinsic value and time value of an option

Intrinsic value (IV) is the amount by which an option is already in‑the‑money. For a call option it is the excess of the underlying spot price (S) over the strike price (K). For a put option it is the excess of the strike price over the spot price.

Mathematically, IV is always a non‑negative number because an out‑of‑the‑money option has zero intrinsic value. The moment the option expires, its intrinsic value becomes the only component of its price – the time value disappears.

In the NISM exam, any question that asks for the "minimum value" of an option or the "value if exercised today" is referring to intrinsic value. Remember: IV does not depend on volatility, interest rates or time left to expiry – only on S and K.

• Call IV = max(0, S – K)
• Put IV = max(0, K – S)

Time value (TV) is the portion of the option premium that exceeds its intrinsic value. It represents the market's expectation of future price movement, volatility, time to expiry, and the cost of carry.

The formula is straightforward: TV = Premium – Intrinsic Value. Because TV reflects optionality, it is always non‑negative; if an option is deep out‑of‑the‑money, the entire premium may be time value.

Exam questions often give the option premium and ask for the time value. Candidates must first compute IV correctly; a wrong IV leads to a negative TV, which is impossible and signals a mistake.

Step 1: Identify whether the option is a call or a put. This determines which intrinsic‑value formula to use.

Step 2: Plug the current spot price (S) and the strike price (K) into the appropriate IV formula. Remember that IV cannot be negative – if the calculation yields a negative number, set IV to zero.

Step 3: Subtract the computed IV from the quoted premium to obtain the time value. If the premium equals IV, the time value is zero, indicating the option is at expiry or the market expects no further movement.

Time value rises with higher implied volatility because the probability of the option moving further in‑the‑money increases. SEBI’s guidelines require that volatility be quoted as an annualised figure, but the concept remains the same for Indian market participants.

Longer time to expiry also adds to time value – the more days remaining, the greater the chance for favorable price swings. This relationship is captured by the Greek "theta", which measures the rate of time decay per day.

Interest rates and dividend yields affect the cost of carry. For index options like NIFTY, the impact is modest, but for equity options on dividend‑paying stocks, a higher expected dividend reduces call time value and raises put time value.