The option premium (or the price of the option), as we have seen, is the price options buyers pay for the right the option confers on them. This price has two components; the intrinsic value and the time value.
The intrinsic value
An option’s intrinsic value is the difference between its strike price and the current market price. The current price can be higher or lower than the strike price depending on the type of stock option.
Time value
This is the portion of the option premium that is not due to the intrinsic value. In essence, the excess of the option premium over the intrinsic value. Time value represents the hope that the current market price can still change to turn an out-of-the-money option into an in-the-money option. Since the possibility of changes in market prices declines as we get closer to expiration, the time value of an option reduces as the option nears expiration.
In fact, at expiration, the time value is exactly zero and the intrinsic value alone represents the value of an option.
Consequently, the price of an option can change as the market price of the underlying asset changes and the expiration date gets closer. The more in-the-money the option, the higher the option premium, and vice versa.
Also, the volatility of an option’s underlying asset will affect its premium. If the stock is very volatile, then the possibility of market price adjusting to turn an out-of-the-money option into an in-the-money option is higher. This results in a higher premium. On the other hand, if the stock is less volatile, then the option premium will be lower when compared to the more volatile option.