When trading options, it's important to understand two definitions:intrinsic value and extrinsic value. It could mean the difference between making money and losing money.

Intrinsic Value

Everybody knows what intrinsic means in regular everyday life: real, innate, inherent, of within.

In options, the concept is the same.

The definition of intrinsic value as it pertains to options is: the difference between the underlying stock price and the option's strike price (that's in-the-money).

For example: if a stock was trading at $50, and a $45 call option with 30 days of time left on it was selling for $6.50, that option would have $5 of intrinsic value.

$50 stock price – $45 call option = $5. If the option premium is worth $6.50, that means $5 of that is intrinsic value.

The other $1.50 of that is extrinsic value, also known as time value.

Extrinsic Value (aka Time Value)

Extrinsic value is the amount of the premium that's not comprised of intrinsic value. This part of the premium is said to be your ‘time value'. Out-of-the-money options are comprised of only time value.

Using the same example as above:

A $6.50 premium – $5 intrinsic value = $1.50 of extrinsic value.

So the key to remember is that options are comprised of two parts: intrinsic value and extrinsic value, i.e., time value.

So what's the difference for the investor?

In the beginning, for all practical purposes, nothing.

If I bought an option at $500 and then sold it for $800, whether half of that was comprised of intrinsic value or none of it was comprised of intrinsic value, it makes no difference from that standpoint.

But ultimately, at expiration, when there's no time left of the option, your option's sole value will be its intrinsic value.

So at that point it makes all the difference.

For example: if I had a $50 call option with 2 months of time on it, and the price of the underlying stock was at $45, that option might be worth $3.50 or $350. And at that point, the premium is comprised on only time value.