**Tutorial: Options Basics**When they establish a position, option sellers collect time-value premiums, paid by option buyers. Rather than struggling against the ravages of time value, the option seller can benefit from the passage of time, and time-value decay becomes money in the bank even if the underlying is stationary. For option writers (sellers), time-value decay thus becomes an ally instead of a foe. If you have ever sold covered calls against stock positions, you can appreciate the beauty of selling time value.

In this article I focus on the importance of time value in the option-pricing equation. But before turning to a detailed look at the phenomenon of time value and time-value decay, let's review some basic option concepts that will make it easier for you to understand what we mean by time value.

**Options and Strike Price**

Depending on where the underlying price is in relation to the option strike price, the option can be in, out or at the money. Let's look at this relationship while keeping in mind our central focus on time value.

When we say an option is at the money, we mean the strike price of the option is equal to the current price of the underlying stock or commodity. When the price of a commodity or stock is the same as the strike price (also known as the exercise price) it has zero intrinsic value, but it also has the maximum level of time value compared to that of all the other option strike prices for the same month. Figure 1 provides a table of possible positions of the underlying in relationship to an option's strike price.

Figure 1 |

In the case of a put option at the same strike price of 1100 and the underlying at 1050, the option at expiration also would be 50 points in the money (1100 -1050 = 50). For out-of-the-money options, the exact reverse applies. That is, to be out of the money, the put's strike would be less than the underlying price, and the call's strike would be greater than the underlying price. Finally, both put and call options would be at the money when the strike price and underlying expire at the exact same price. While we are referring here to the position of the option at expiration, the same rules apply at any time before the options expire.

**Time-Value of Money**

Watch: The Time Value Of Money |

*Understanding The Time Value Of Money*.)

Figure 2 |

**Time-Value Decay**

In Figure 3 below, we simulate time-value decay using three at-the-money S&P 500 call options, all having the same strikes but different contract expiration dates. This should make the above concepts more tangible. Through this presentation, we are making the assumption (for simplification) that implied volatility levels remain unchanged and that the underlying is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer.

Taking our series of S&P 500 call options, all with an at-the-money strike price of 1100, we can simulate how time value influences an option's price. Assume the date is Feb 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates (Feb, March and April), the phenomenon of time-value decay becomes evident. We can witness how the passage of time changes the value of the options. Figure 3 graphically illustrates the premium for these at-the-money S&P 500 call options with the same strikes. With the underlying stationary, the Feb call option has five days remaining until expiry, the Mar call option has 33 days remaining and the Apr call option has 68 days.

As Figure 3 shows, the highest premium is at the 68-day interval (remember prices are from Feb 8), declining from there as we move to the options that are closer to expiration (33 days and five days). Again, we are simply taking different prices at one point in time for an at-the-option strike (1100), and comparing them. The fewer days remaining translates into less time value. As you can see, the option premium declines from 38.90 to 25.70 when we move from the strike 68 days out to the strike that is only 33 days out.

Figure 3 |

Figure 4 |

The concept looked at in another way in Figure 4, the amount of days required for a $1 (1 point) decline in premium on the option will decrease as expiry nears.

**The Bottom Line**

While there are other pricing dimensions (such as delta, gamma, and implied volatility), a look at time-value decay is a good place to start when beginning to understand how options are priced.