Understanding the Time Value of Options
Time value refers to the portion of an option’s premium attributed to the amount of time remaining until the option contract expires. The total premium of any option consists of two key components: its intrinsic value and its extrinsic value. Time value is a component of extrinsic value alongside implied volatility (IV) and specifically relates to derivatives markets.
Key Insight of Time Value
- Two Key Components: Time value and implied volatility form an option’s extrinsic value.
- Total Price Instantiation: An option’s total price comprises its intrinsic value plus its extrinsic value.
- Transient Attribute: More remaining time generally increases an option’s time value.
Fundamentals of Time Value
The price or cost of an option, known as the premium, is what an option buyer pays to an option seller for the right to buy or sell an asset, or to let the option expire worthless. Intrinsic value is the difference between the price of the underlying asset and the strike price of the option. For call options, intrinsic value equals the underlying price minus the strike price. For put options, which provide the right to sell, intrinsic value equals the strike price minus the underlying price.
The entire premium is based on both intrinsic and extrinsic values, and the time value is a significant part of extrinsic value. As expiration approaches, the value usually drops since there’s less time for favorable asset movement. An option far from its expiration but out of the money will typically have more extrinsic value than one with less time to expiration. More time until expiration generally means higher time value.
Additionally, implied volatility impacts both extrinsic and time values. It measures possible movements of the underlying asset over a specified period, and increased IV usually leads to heightened extrinsic value. If a call option’s annualized IV of 20% jumps to 30%, the extrinsic value rises as investors expect more substantial price swings.
Calculating Time Value
The equation representing time value is:
Option Premium - Intrinsic Value = Time Value + Implied Volatility
Premium amount exceeding an option’s intrinsic value represents its time value. For example, if Alphabet Inc. stock is priced at $1,044 per share and its $950 call option trades at $97, the call option has an intrinsic value of $94 ($1,044 - $950) and a time value of $3 ($97 - $94).
The Significance of Time Value
More remaining time generally translates into greater time value for options because more time provides increased chances for favorable asset moves, increasing likelihood of profitability. Buyers are willing to pay higher premiums for such options. Conversely, options nearing expiration lose premium value as profitability chances fade, making safer to sell or hold rather than exercising it when some time value remains.
Time value decreases over time rapidly, known as time decay or time-value decay, and the rate of this decay can be understood through theta. Generally, an option loses about one-third of its time value in the first half of its life, and about two-thirds during the second half.
Gradient of Relevant Terms Explained
What Is a Call Option?
A call option grants the right, without the obligation, to buy a security at an agreed price before expiration. The seller is obliged to comply with this price.
Defined: What Does “In the Money” Mean?
An option is “in the money” (ITM) when it possesses both time and intrinsic value. For a call option, this occurs when the underlying asset’s price exceeds the strike price.
Trading Concept: What Does Delta Mean?
Delta measures how likely an option’s price is to change corresponding to movements in the underlying security. For a $1 change, an option’s price increases proportionately with its delta value.
Concluding Thoughts
Time value significantly contributes to an option’s premium and depends on the remaining time until expiration. Maximizing option profitability hinges on understanding this intricacy, along with its extrinsic versus intrinsic components and underlying asset volatility. Investors usually prefer extended timeframes for allowing more substantial profitable spans.
Related Terms: Intrinsic Value, Extrinsic Value, Implied Volatility, Option Premium, Call Option, Put Option.
References
- Merrill. “Options Pricing”.
- Charles Schwab Corporation. “Theta Decay in Options Trading”.
- FINRA. “Options / Key Terms”.
- Britannica Money. “In the Money”.
- Charles Schwab Corporation. “Get to Know the Option Greeks”.
