What Is Time Value?
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 extrinsic value.
Time value is a component of an option's extrinsic value, alongside implied volatility (IV), and relates to derivatives markets. It should not be confused with the time value of money (TVM), which describes the discounting of money's purchasing power over time.
- Time value is one of two key components, the other being implied volatility, that comprise an option's extrinsic value.
- An option's total price, or premium, is the aggregation of its intrinsic and extrinsic value.
- Generally, the more time that remains until the option expires, the greater the time value of the option.
The Basics of Time Value
The price (or cost) of an option is an amount of money known as the premium. An option buyer pays this premium to an option seller in exchange for the right granted by the option: the choice to exercise the option to buy or sell an asset or to allow it to expire worthless.
The intrinsic value is the difference between the price of the underlying asset and the strike price of the option. The intrinsic value for a call option—the right, but not the obligation, to buy an asset—is equal to the underlying price minus the strike price, while the intrinsic value for a put option—the right to sell an asset—is equal to the strike price minus the underlying price.
An option's total premium is based on its intrinsic plus extrinsic value. A key part of extrinsic value is known as "time value." Under normal circumstances, a contract loses value as it approaches its expiration date because there is less time for the underlying security to move favorably. In other words, an option with one month to expiration that is out of the money (OTM) will have more extrinsic value than that of an OTM option with one week to expiration.
Typically, the more time that remains until the option expires, the greater its time value, as the contract will have longer to become profitable.
Another factor that affects extrinsic value and time value is implied volatility (IV). IV measures the amount an underlying asset may move over a specified period. If the IV increases, the extrinsic value will also increase. For instance, if an investor purchases a call option with an annualized IV of 20% and the IV jumps to 30% the following day, the extrinsic value would rise as investors figure that dramatic moves boost the possibility of the asset moving their way.
Calculating Time Value
As an equation, time value might be expressed as:
Option Premium - Intrinsic Value = Time Value + Implied Volatility
Or, to put it another way: the amount of a premium that is in excess of the option's intrinsic value is referred to as its time value. For example, if Alphabet Inc. stock is priced at $1,044 per share and the Alphabet Inc. $950 call option is trading at $97, then the option has an intrinsic value of $94 ($1,044 - $950) and a time value of $3 ($97 - $94).
The Significance of Time Value
As a general rule, the more time that remains until expiration, the greater the time value of the option. The rationale is simple: Investors are willing to pay a higher premium for more time since the contract will have longer to profit from a favorable move in the underlying asset.
Conversely, the less time that remains on an option, the less of a premium investors are willing to pay, because the probability of the option having the chance to be profitable is shrinking. For this reason, it's safer to sell or hold an option that still has time value left, rather than exercising it; otherwise, that remaining time value would be lost.
Theoretically, adding time to an option or increasing the IV have the same fundamental effect: increasing the probability that an option will finish in the money (ITM).
In general, an option loses one-third of its time value during the first half of its life, and the remaining two-thirds of its time value during the second half. Time value decreases over time at an accelerating pace, a phenomenon known as time decay or time-value decay. An option price's sensitivity to time decay is known as its theta.