Option time value
In finance, the time value (TV) (extrinsic or instrumental value) of an option is the premium a rational investor would pay over its current exercise value (intrinsic value), based on the probability it will increase in value before expiry. For an American option this value is always greater than zero in a fair market, thus an option is always worth more than its current exercise value. For a European option, the extrinsic value can be negative. As an option can be thought of as 'price insurance' (e.g., an airline insuring against unexpected soaring fuel costs caused by a hurricane), TV can be thought of as the risk premium the option seller charges the buyer—the higher the expected risk (volatility time), the higher the premium. Conversely, TV can be thought of as the price an investor is willing to pay for potential upside.
TV decays to zero at expiration, with a general rule that it will lose 1⁄3 of its value during the first half of its life and 2⁄3 in the second half. As an option moves closer to expiry, moving its price requires an increasingly larger move in the price of the underlying security.
The intrinsic value (IV) of an option is the value of exercising it now. If the price of the underlying stock is above a call option strike price, the option has a positive monetary value, and is referred to as being in-the-money. If the underlying stock is priced cheaper than the call option's strike price, the call option is referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder simply abandons the option and it expires worthless. Hence, a purchased option can never have a negative value. This is because a rational investor would choose to buy the underlying stock at market rather than exercise an out-of-the-money call option to buy the same stock at a higher-than-market price.
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