The time value of an option refers to the additional premium (or extrinsic value) of an option beyond its intrinsic value.
An easy way to think about time value is that it is the portion of an option’s price (or position) that contains the current odds of it finishing in the money. At expiration those odds are worthless as the stock’s close is no known, and the only value left in any option is its extrinsic value, the stock price plus or minus that strike price.
To illustrate, assume a stock is trading 100. The 105 call is trading $2. The entire option is extrinsic premium, with $2 of time value.
Next, a 95 call (which is $5 in the money) is trading $9. That option consists of $5 in intrinsic value, and then $4 of extrinsic time value.
An option position’s time value will decrease towards zero as expiration approaches. In the examples above, if the stock finished on expiration Friday at $100, the 105 call would be worthless, losing all $2 in time value, and the 95 call would be worth $5, losing all $4 of its time value, but remaining worth $5 of its intrinsic value (100 stock – 95 call strike).
