A time premium is the amount by which the price of a stock option exceeds its intrinsic value. If a $50 call on a $53 stock is trading for five dollars, it has three dollars of intrinsic value and two dollars of time premium. An out of the money option is all time premium. A stock option reaches its highest level of time premium when the stock and the strike price are equal (at the money). This is because the option has no intrinsic value yet it is about to gain intrinsic value. As the option moves further and further in the money, the intrinsic value increases and the time premium decreases as a percentage of the total price of the stock option. The fact that at the money stock options have the greatest time premium does not mean they are expensive. The implied volatility can be higher for out of the money options. Buying at the money stock options can be an effective strategy if you believe the stock will make a fairly large move. Time premium is also called time value.
December 10, 20081 min read