Stock and Option Trading has Special Value
Stock and option trading has special value components that make up the premium. The premium is the determination of the option’s value and it is also the price at which the option was traded most recently.
You may think that stock and option trading bidders or traders bid on option contracts using the strike price. That is not true. A trader makes a bid on an option price and is actually bidding on the option premium. On the other side of the transaction, the trader makes an offer which is the premium price he or she is willing to sell the option at.
In stock option trading, when you bid on an option, you must have the amount of the premium in your trading account. At the end of each day, it is the premium value that is used to calculate account value for reporting your option position. This is an important concept to understand in stock and option trading because it is the foundation of the profit or loss calculation.
Intrinsic and Time Value of the Premium
Understanding what makes up the premium is very important to understanding what makes options tick. The stock and option trading premium has two major components.
Intrinsic Value
Intrinsic value applies to options that are in the money. In the money is a term that applies to options in which the price of the underlying asset is higher than the option strike price. Intrinsic value is the actual value related to the strike price and the futures price. This is the first value component in stock and option trading.
When a call option (right to buy or go long) has a strike price that is lower than the futures price, there is intrinsic value. For example, a stock has a futures market value of $20. An $18 call would mean there is $2 of intrinsic value in the premium.
A put option (right to sell or go short) has a strike price that is higher than the futures price. In another example, a stock with a futures market price of $20 and a $23 put then there is $3 intrinsic value.
Time Value
Time value, or risk value, is the extrinsic value of the stock option. It is the amount of premium that is above the intrinsic value. If the strike value equals the futures value, there is no intrinsic value so the entire premium is made up of time value only.
In other words, time value is the portion of the premium value that is related to the risk of selling the option. An option that is out of the money (futures price has not hit the strike price in direction of the option) or at the money does not have intrinsic value.
When stock and option trading, the longer the time left until the expiration date, the more risk there is of the market changing so time value is higher. The time value will decline the closer the option gets to the expiration date. This is referred to as time decay in stock and option trading.
In stock and option trading, the value of time and the concept of time decay are important to understand. Time value decay, as it concerns buying and selling options, is how you can measure the possible rate of premium loss.
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Filed under All About Options by on Apr 2nd, 2011. 
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