The Importance of Time Value in Options Trading

Intrinsic Value vs. Time Value
  In-the-money Out-of-the money At-the-money
Put/Call Time-value decreases as an option gets deeper in the cash; intrinsic value increases. Time-value decreases as an option gets deeper out of the cash; intrinsic value is zero. Time-value is at a maximum when an option is at the cash; intrinsic value is zero.
Note: Intrinsic value arises when an option gets in the cash.

Time Value Decay

Within the figure below, we simulate time-value decay using three at-the-money S&P 500 call options, all with the identical strikes but different contract expiration dates. This could make the above concepts more tangible. Through this presentation, we’re making the idea (for simplification) that implied volatility levels remain unchanged and the underlying asset is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus turn into much clearer.

Taking our series of S&P 500 call options, all with an at-the-money strike price of 1,100, we will simulate how time value influences an option’s price. Assume the date is Feb. 8. If we compare the costs of every option at a certain moment in time, each with different expiration dates (February, March, and April), the phenomenon of time-value decay becomes evident. We are able to witness how the passage of time changes the worth of the choices.

The figure below illustrates the premium for these at-the-money S&P 500 call options with the identical strikes. With the underlying asset stationary, the February call option has five days remaining until expiry, the March call option has 33 days remaining, and the April call option has 68 days remaining.

Because the figure below shows, the very best premium is on the 68-day interval (remember prices are from Feb. 8), declining from there as we move to the choices which can be closer to expiration (33 days and five days). Again, we’re simply taking different prices at one cut-off date for an at-the-option strike (1100), and comparing them. The less days remaining translates into less time value. As you’ll be able to see, the choice premium declines from $38.90 to $25.70 once we move from the strike 68 days out to the strike that is just 33 days out.

Image by Julie Bang © Investopedia 2019 

The subsequent level of the premium, a decline of 14.7 points to $11, reflects just five days remaining before expiration for that individual option. Throughout the last five days of that option, if it stays out of the cash (the S&P 500 stock index below 1,100 at expiration), the choice value will fall to zero, and this can happen in only five days. Each point is price $250 on an S&P 500 option.

One essential dynamic of time-value decay is that the speed shouldn’t be constant. As expiration nears, the speed of time-value decay (theta) increases (not shown here). Which means that the period of time premium disappearing from the choice’s price per day is larger with each passing day.

The concept is checked out in one other way within the figure below: The variety of days required for a $1 (1 point) decline in premium on the choice will decrease as expiry nears.

Image by Julie Bang © Investopedia 2019 

This shows that at 68 days remaining until expiration, a $1 decline in premium takes 1.75 days. But at just 33 days remaining until expiration, the time required for a $1 loss in premium has fallen to 1.28 days. Within the last month of the lifetime of an option, theta increases sharply, and the times required for a one-point decline in premium falls rapidly.

At five days remaining until expiration, the choice is losing one point in only lower than half a day (0.45 days). If we glance again on the Time-Value Decay figure, at five days remaining until expiration, this at-the-money S&P 500 call option has 11 points in premium. Which means that the premium will decline by roughly 2.2 points per day. In fact, the speed increases much more in the ultimate day of trading, which we don’t show here.

How Is an Option’s Time Decay Measured?

Options traders use the Greek value Theta (Θ) to measure time decay, and interpret it because the dollar change in an option’s premium given one additional day to expiration, all else equal. Due to this fact, an option with a premium of $2.30 and a theta of $0.05 might be price $2.25 the subsequent day, assuming nothing else changes.

Which Options Have the Best Time Value?

At-the-money options have the best time value (and are also most sensitive to time decay, as measured by theta). Furthermore, options approaching expiration see their time decay speed up the fastest relative to those with longer expirations remaining.

Why Is Time Value of Options Also Called Extrinsic Value?

An option’s premium consists of two parts: intrinsic and extrinsic value. Intrinsic value is the amount of cash the choice incorporates if it were exercised immediately. As an example, a 30-strike call lets you buy shares at $30, and if the stock is trading at $35, there must be $5 of intrinsic value in that decision. Extrinsic value is anything above the intrinsic value. So, when you as an alternative owned the 40-strike call when the stock is trading at $35, it would not be price anything to exercise in the intervening time. But, there would still be a premium, or the extrinsic value, which relies on the probabilities that this feature will pan out before expiration. This relies on the time value of the choice, because the more time there stays, the more possibilities the stock will rise above $40.

The Bottom Line

While there are other pricing dimensions (corresponding to delta, gamma, and implied volatility), a have a look at time-value decay is useful to grasp how options are priced.

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