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Three Different Kinds Of Option Premium

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Have you ever noticed how a strong movement in the price of stock is often not matched by changes in option value? The option premium might move fewer points even when it is in the money, or in some cases move even more. Why?

Most options traders are aware of two kinds of premium - intrinsic value and time value. In fact, there are three and in order to understand how premium levels change, you need to break time value down into two separate parts.

Intrinsic value is a straightforward type to understand. Any time a stock's price is higher than a call's strike, that strike is "in the money." The number of points in the money is the option's intrinsic value. For example, the strike is 30 and the current value of the underlying stock is $33 per share. There are three points of intrinsic value.

For a put, the direction is the opposite. When the current value of the stock is lower than the put's strike, the strike is in the money. So if the strike is 50 and the current value of the stock is $48 per share, the put is two points in the money.

Whenever an option is out of the money, there is no intrinsic value.

Time value has two parts. The part that is strictly defined as time value is nothing more than the value assigned to the distance to expiration. The farther away expiration, the higher the time value. Time decay accelerates as expiration approaches, losing the most in the last two months. By expiration day, time value will be at or near zero. The rate of accelerated decline looks similar to the decline of principal in a 30-year mortgage payment. The drop takes place more toward the end of the term.

Time value is predictable, just like intrinsic value. However, there remains a third kind of option premium, and this is where all of the uncertainty resides.

Most definitions of time value fold all non-intrinsic value into one number. But this is misleading, because whereas time value is predictable, the extrinsic, or volatility value is not predictable at all.

Extrinsic value is the premium that changes based on volume of trading in the underlying stock as well as in the option. It is affected by several things: Proximity of current value to strike price, time remaining to expiration, stock trading volume, and trading and open interest in the relevant option itself. The collective factors that move option premium up or down, at times counter-acting intrinsic value itself, is called implied volatility, or the change in value of the option based on perceived future price direction of the underlying stock.

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