<p>The time value of an option is the portion of its premium that exceeds <a href="/NewSite/encyclopedia/intrinsic-value/" class="ency-link">intrinsic value</a>, reflecting the potential for the underlying asset’s price to move favorably before expiration.</p>

<h2>How It Works</h2>
<p>An option’s total premium consists of two components: intrinsic value and time value.</p>
<ul>
<li><strong>Intrinsic value</strong> is the immediate payoff if the option were exercised now — calculated as the difference between the underlying price and the strike price for calls, or the strike price and underlying price for puts, with a floor of zero.</li>
<li><strong>Time value</strong> captures the remaining premium, influenced by factors such as time to expiration, volatility, interest rates, and dividends. As expiration approaches, time value erodes, a process known as <a href="/NewSite/encyclopedia/theta/" class="ency-link">theta</a> decay.</li>
<li>Mathematically: <strong>Premium = Intrinsic Value + Time Value</strong>. When an option is deep in‑the‑money, intrinsic value dominates; when it is out‑of‑the‑money or at‑the‑money, the premium is largely time value.</li>
</ul>

<h2>Why It Matters</h2>
<p>Understanding time value helps traders assess whether an option’s price is justified by its remaining life and market expectations.</p>
<ul>
<li>For example, a call option on a stock trading at $100 with a strike price of $95 has $5 of intrinsic value. If the option’s market price is $7, the extra $2 represents time value, rewarding the holder for the chance that the stock could rise above $105 before expiry.</li>
<li>Monitoring time value decay (theta) enables sellers to profit from premium erosion and buyers to anticipate the cost of holding a position.</li>
<li>In risk management, distinguishing intrinsic from time value clarifies how much of an option’s price is attributable to actual price advantage versus speculative potential.</li>
</ul>