56  •   The Intelligent Option Investor
This is so because the area of the range of exposure for the option on 
the left that is bounded by the BSM probability cone is much smaller than 
the range of exposure for the option on the right that is bounded by the 
same BSM probability cone.
Time Value versus Intrinsic Value
One thing that I hope you will have noticed is that so far we have talked 
about options that are either out of the money (OTM) or at the money 
(ATM). In-the-money (ITM) options—options whose range of exposure 
already contains the present stock price—may be bought and sold in just 
the same way as ATM and OTM options, and the pricing principle is ex-
actly the same. That is, an ITM option is priced in proportion to how much 
of its range of exposure is contained within the BSM probability cone.
However, if we think about the case of an OTM call option, we realize 
that the price we are paying to gain access to the stock’s upside potential 
is based completely on potentiality. Contrast this case with the case of an 
ITM call option, where an investor is paying not only for potential upside 
exposure but also for actual upside as well. 
It makes sense that when we think about pricing for an ITM call option, 
we divide the total option price into one portion that represents the poten-
tial for future upside and another portion that represents the actual upside. 
These two portions are known by the terms time value and intrinsic value, 
respectively. It is easier to understand this concept if we look at a specific 
example, so let’s consider the case of purchasing a call option struck at $40 
and having it expire in one year for a stock presently trading at $50 per share. 
We know that a call option deals with the upside potential of a stock 
and that buying a call option allows an investor to gain exposure to that up-
side potential. As such, if we buy a call option struck at $40, we have access 
to all the upside potential over that $40 mark. Because the stock is trading 
at $50 right now, we are buying two bits of upside: the actual bit and the 
potential bit. The actual upside we are buying is $10 worth (= $50 − $40) 
and is termed the intrinsic value of the option. 
A simple way to think of intrinsic value that is valid for both call options 
and put options is the amount by which an option is ITM. However, the option’s 
cost will be greater than only the intrinsic value as long as there is still time