Time value of options
In options trading, time value refers to the portion of an option's premium that is attributable to the amount of time remaining until the expiration of the option contract. The premium of any option consists of two components: its intrinsic value and its time value. The total premium of an option is equal to the intrinsic value plus the option's time value. Time value is also known as extrinsic value. The Basics of Time Value The price or cost of an option is an amount of money known as the premium.
Glossary Time value of options does time value counter options option options depend on? There are more factors influencing time value of an option. Among the most important are time to expiration, interest rates, and moneyness — or whether an option is in the money, at the money, or out of the moneyand how far.
This article deals with the last factor mentioned.
The worst case scenario is that you will be holding the option until expiration and the option will expire worthless. Market price of every option is the sum of its intrinsic value and time value. When you add up the two, you get your maximum risk.
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Deep in the money call option When an option is deep in the money, you risk a lot in intrinsic value. For example, you have an option with a strike price of 20 on a stock which currently trades at The intrinsic value of this option is 30 dollars per share and you can theoretically lose this all if the stock falls sharply under So your total risk as the owner of this option is its market price, equal to intrinsic value plus time value.
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At the money call option Now compare this with another option on the same stock, but with the strike price of Because the underlying stock trades also at 50, the option is at the money.
The intrinsic value of this option is zero.
Intrinsic value and time value of an option
Your total risk as the owner of this option is its market price which in this case equals only its time value. Now what would your total risk be in each case?
Option time value
In the at the money option example your total risk would be just the 2 dollars. Profit potential of call options Is the profit potential of the two options different?
Both are call options on the same stock and both would make you a profit if the stock trades above 52 at expiration assuming you would wait till expiration and then exercise the options.
Your total profit from holding the option in both cases is 1 dollar for every dollar by which the price of the underlying stock will exceed 52 market price of the underlying stock at the moment of buying the option plus time value of the option at the moment of buying the option.
People prefer less risk to more risk with same profit potential So what would you prefer to do? Risk 32 dollars or risk 2 dollars if the profit potential is the same in both cases?
Time Value Definition
Of course every rational person would prefer to risk less. This is why in reality the time value of the at the money option would be higher than the time value of the deep in the money option. People are willing to pay an extra price in the time value for reducing their risk.
Note: Intrinsic value arises when an option gets in the money.
Consider buying the stock itself instead of buying the options. A stock has no time value, as there is no optionality in it. In fact a stock is like a call option with a strike price of zero and the underlying asset is the stock itself.
Time Value of In The Money Call Options
If you own a time value of options, your maximum risk is its market price. You can look at long stock as an extremely deep in the money call option with zero strike and zero time value. Conclusion: time is worth the most at the money The reason is that the ratio of expected profit to maximum risk is the best here and therefore the benefit from having the choice to exercise or not is the greatest here.
For in the money call options, the closer an option is to a long stock position — this means the lower its strike price is — the smaller its time value will be.
The time value will increase as the option gets closer to the at the money area.