A call option lets you buy a stock's shares at a fixed price, which is called the strike price. When the stock's market price exceeds the strike price, the option has an exercise value. Yet the option premium, which is the price you pay for the option, exceeds this intrinsic value. The option premium, also known as the extrinsic value, also includes the option's time value. This additional value accounts for the advantage in buying an option long before exercising it.
Assign the call option a time value. If you invest in the option at or soon before the expiration date, it will have none or little time value. At this point, the option will also have little intrinsic value because the market will drive its strike price to the current stock price. Options with later expiration dates offer more time value so long as you expect the stock price to rise. For this example, suppose that your option has a time value of $30.
Subtract the option's strike price from its predicted stock price. For example, if an option allows you to buy a stock at $70 and you plan to exercise it once it the stock price hits $95, subtract $70 from $95 to get $25. This is the option's intrinsic value.
Add the option's intrinsic and time values. With this example, add $25 to $30 to get $55. This is the option premium.
With most financial instruments, "premium" refers to a price above an objective value. For instance, an investor might call an option's time value a "time premium." Yet the option premium, unlike other security premiums, includes both the intrinsic and extrinsic value of the option.
- University of Missouri: Commodity Futures Terminology
- Intermediate Financial Management; Eugene F. Brigham, Phillip R. Daves; 2009
- Commodity and Financial Derivatives; S. Kevin; 2010
- Portfolio Construction, Management and Protection; Robert A. Strong; 2008