There are several components to the value of a call or put option trade. An option's value is made up of its intrinsic value plus a time premium. The current value of your option trade depends on the price you paid, as well as the underlying stock price relative to the strike price of your option contract.

Two components of an option's price

When you buy a call or put option contract, the price you pay is made up of two distinct components:

  • Time premium, also known as time value
  • Intrinsic value, or the current value of the option, also known as the gross value
Traders looking at stock quotes on a monitor.

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The time premium, or the option's time value, is the portion of the option's price that you pay for the uncertainty of the option's price until expiration. In other words, this is the amount you're paying for what the underlying stock could be worth in the future.

The intrinsic, or gross, value of an option is the amount the option is in the money. For example, if you have the option to pay $10 per share for a stock that trades for $15, the option has an intrinsic value of $5 per share.

In addition, the current value of an option trade is your net result if you were to exercise the contract today. In other words, this is the current intrinsic value of the option, minus the price you paid for it. For example, if you paid $3 per share for a contract to buy a stock for $10 that currently trades for $12 ($2 intrinsic value), you would currently experience a loss of $1 per share if you exercised the option. Therefore, the current value of your option trade is negative $1 per share.

Examples

To illustrate these principles, consider a few examples:

First, let's say that Microsoft is trading for $50 per share, and you buy a call option that allows you to purchase 100 shares of the stock for $60 at any time within the next year, and pay $1 per share. Since the option is out of the money, it has no intrinsic value. The $1 per share price of the option represents the time premium you pay, since there are infinite possibilities of the stock's price movement within the next year.

If Microsoft's stock price increases to $65, your option will be in the money by $5 per share (intrinsic value). Since you paid $1 per share to buy the option, the current value of your option trade will be $4 at that point.

As another example, let's say that Apple is trading for $150 per share, and you buy a call option that allows you to purchase 100 shares within the next year at a strike price of $135. You pay $18 per share to purchase the option contract. Since the option is in-the-money by $15 per share, that amount represents the option's intrinsic value. The difference between the intrinsic value and the price you pay for the option, or $3, represents the time premium.

Now, let's say that Apple's stock price falls to $130. Your option is no longer in the money, so it has no intrinsic value. However, you paid $18 to buy the option, so your trade's current value is negative $18 per share, or negative $1,800 altogether.

Calculating the value of your options

Here's a few more details on the difference between call and put options, as well as a calculator that can help you determine the value of yours. (Note: Gross value of the option in the calculator is the same as the intrinsic value concept I discussed earlier.)

 

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Matthew Frankel owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has a disclosure policy.