How do I decompose an option's price into intrinsic value and time value?

Option value decomposition is fundamental to CFA Level I derivatives and comes up in practically every exam.

Definitions

Intrinsic Value = The value if the option were exercised immediately

• Call: max(S - K, 0)
• Put: max(K - S, 0)
• Can NEVER be negative (the holder would simply not exercise)

Time Value = Option Premium - Intrinsic Value

• Reflects the probability that the option becomes more valuable before expiration
• Always non-negative for American options (can be slightly negative for deep ITM European puts)

Worked Example — Fenwick Options Portfolio

Fenwick holds several options on Alderton Corp stock, currently trading at $72.

Time Value Behavior

At-the-money options have the most time value. This is because ATM options have maximum uncertainty about whether they will finish in or out of the money.

Time value decays as expiration approaches — this is called theta decay or time decay. The decay accelerates in the final weeks before expiration.

Key Exam Points

1. OTM and ATM options are 100% time value — their intrinsic value is zero.
2. At expiration, time value is zero and premium equals intrinsic value.
3. Deep ITM options are mostly intrinsic value with little time value — they behave almost like the underlying.
4. Intrinsic value cannot be negative — the floor is always zero. An OTM option has zero intrinsic value, not negative intrinsic value.

Exam tip: If given an option premium and asked "what happens at expiration," the answer is always that the option is worth its intrinsic value (or zero if OTM).

Practice more options questions in our CFA Level I question bank.