The Intelligent Investor’s Guide to Option Pricing  •  57
before the option expires. The reason for this is that although the intrinsic value 
represents the actual upside of the stock’s price over the option strike price, 
there is still the possibility that the stock price will move further upward in the 
future. This possibility for the stock to move further upward is the potential bit 
mentioned earlier. Formally, this is called the time value of an option.
Let us say that our one-year call option struck at $40 on a $50 stock 
costs $11.20. Here is the breakdown of this example’s option price into in-
trinsic and time value:
 $10.00 Intrinsic value: the amount by which the option is ITM
+ $1.20 Time value: represents the future upside potential of the stock
= $11.20 Overall option price
Recall that earlier in this book I mentioned that it is almost always a mis-
take to exercise a call option when it is ITM. The reason that it is almost always 
a mistake is the existence of time value. If we exercised the preceding option, 
we would generate a gain of exactly the amount of intrinsic value—$10. How-
ever, if instead we sold the preceding option, we would generate a gain totaling 
both the intrinsic value and the time value—$11.20 in this example—and then 
we could use that gain to purchase the stock in the open market if we wanted.
Our way of representing the purchase of an ITM call option from a 
risk-reward perspective is as follows:
Advanced Building Corp. (ABC)
5/18/2012 5/20/2013 249 499 749
EBP = $51.25
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