The option premium is always greater than the intrinsic value. This extra money is for the risk which the option writer/seller is undertaking and is called the Time Value.
Time value is the amount the option trader pays over and above the intrinsic value for the option contract which he believes will increase because of favourable change in the price of the underlying asset before the contract expires.
Time value of option = Premium – Intrinsic Value
- Longer the amount of time until the expiry of the contract, the greater the time value.
- Lesser the time to expiry, option premium follows the intrinsic value more closely.
- On the expiry date, Time Value approaches zero.
Take for example: On 9th February 2015, NIFTY 26 Feb2015 8,500 Call (Long) option is trading at Rs. 170 while NIFTY is at 8,525 level.
Intrinsic value of the NIFTY 8,500 Call will be 8525 – 8500 i.e. Rs. 25.
Time value of the Call option = Rs. 170 – 25 = Rs. 145.