What an option price is made of

An option premium looks like one number and is two. Separating them explains almost everything about how options behave.

The split

premium = intrinsic value + time value

Intrinsic value is what the option would be worth if exercised right now. For a call, the amount the underlying is above the strike; for a put, the amount it is below. Never less than zero — an option that is worthless to exercise has no intrinsic value rather than a negative one.

Time value is everything else. It is what you are paying for the possibility that the underlying moves favourably before expiry.

A 24,000 call with the index at 24,100 and a premium of ₹180 has ₹100 of intrinsic value and ₹80 of time value. The ₹100 is already there; the ₹80 is a payment for what might happen next.

Time value only goes one way

This is the fact that catches option buyers.

Intrinsic value moves with the underlying — up and down, freely. Time value shrinks, always, as expiry approaches. There is less time for something to happen, so the possibility is worth less.

And it does not shrink evenly. Decay accelerates towards expiry. An option with thirty days left loses time value slowly; the same option in its final two days loses it quickly; at expiry time value is exactly zero and only intrinsic value remains.

So an option buyer whose underlying does nothing loses money every single day. Not because they were wrong — because they ran out of the thing they bought.

This is the structural reason most bought options expire worthless. An out-of-the-money option has no intrinsic value at all: its entire premium is time value, and time value goes to zero with certainty. For such an option to pay, the underlying has to move far enough, fast enough, to create intrinsic value before the clock finishes.

The other side of the same fact

Every rupee of time value the buyer loses, the seller keeps.

That is why selling options is described as earning income: you are selling a wasting asset, and waiting is your friend rather than your enemy. Chapter 9 is about what else comes with that position.

What moves the premium

Four things, and knowing which is which stops a lot of confusion.

The underlying's price. Obvious, and the one people watch. A call gains as the underlying rises.

Time remaining. Covered above. Works against the buyer, for the seller, every day.

Volatility. How much the underlying is expected to move. More expected movement means more chance the option finishes in the money, so a higher premium — for calls and puts alike.

This one is worth sitting with, because it is the least intuitive. An option can lose money while the underlying moves in your favour, if expected volatility falls at the same time. Buying options before a big event and holding through it is a classic way to be right about direction and still lose: once the event passes, uncertainty collapses and the premium with it.

Interest rates, which matter least over the horizons an individual trades.

Implied volatility

Reverse the pricing: take the premium the market is charging and work out what level of future movement would justify it. That figure is implied volatility, and it is the market's expectation of movement, stated as a number.

Two uses, one honest and one a trap.

Honest: it tells you whether options are expensive or cheap relative to their own history. High implied volatility means the market is charging a lot for uncertainty.

The trap: "options are cheap" is not a reason to buy them. They may be cheap because nothing is expected to happen, and nothing happening is the outcome in which a bought option goes to zero.

Why expiry day is different

Chapter 4 noted SEBI's concern about "an explosion in index options trading on expiry day", and the increased tail risk coverage imposed on that day. This chapter is why.

On expiry day, time value is nearly gone and the entire premium is a bet on the final hours. Options worth a few rupees can multiply or go to zero within minutes, because the numbers are small and intrinsic value is all that will remain.

The percentage swings are genuine and they are percentages of a deliberately small number. That combination — real volatility, tiny base — is what makes expiry day attract volume and lose money.

The point

A premium is intrinsic value plus time value. Intrinsic value moves both ways with the underlying; time value only shrinks, and fastest at the end. An out-of-the-money option is entirely time value, so it goes to zero unless the underlying moves far enough in time — and an option can fall even when the underlying moves your way, if expected volatility falls with it.