The importance of time value in options trading

This should make the above concepts more tangible. Thanks so much for your kindness in publishing it! I ended up coming out of the trade profitable. Save your draft before refreshing this page. Conversely, as the time to decide to choose becomes smaller and smaller, the value of the choice erodes with the reduction of time.

As Figure 2 indicates, deep in-the-money options and deep out-of-the-money options have little time value. Intrinsic value increases the more in the money the option becomes. And at-the-money options have the maximum level of time value but no intrinsic value.

How decay works either for or against you

Basically, an option's time value is largely determined by the amount of volatility that the market believes the stock will exhibit before expiration. If the market does not expect the stock to move much, then the option's time value will be relatively low.

Meanwhile, the opposite is true for stocks that are expected to be very volatile. High-beta stocks, or those that tend to be more volatile than the general market, usually have very high time values because of the uncertainty of the stock price prior to an option's expiration.

Our in-depth tools give millions of people across the globe highly detailed and thoroughly explained answers to their most important financial questions. Each month, more than 1 million visitors in countries across the globe turn to InvestingAnswers. Financial Dictionary Calculators Articles. That's a way of measuring how much the stock zigzags up and down. In theory, higher volatility means higher option value, but in practice it exposes you to a lot of risk, and that's a negative factor that cancels out the higher value, in my opinion.

For planning purposes, I nearly always determine the value of employee stock options as if the stock has moderate volatility, even if the actual volatility produces a higher theoretical value. These observations about subjective value allow us to use some shortcuts. The easiest one is for brand new options that have a life of five or more years. The option doesn't have any intrinsic value yet because the exercise price is the same as the market value of the stock.

If you've held your option for a while and the stock price has gone up, you need a slightly more complicated method to determine the option's value. The "official" formula is truly mind-boggling, but the following procedure gives you a reasonable estimate:. The time value of a stock option is always somewhere between zero and the exercise price of the option. A number outside that range indicates a mistake. You probably won't be able to do this calculation in your head, but it's pretty easy with a calculator, and that's more than we can say for the Black-Scholes formula.

Bear in mind that here again we're ignoring the added value of high volatility, so the theoretical value of a stock option may be higher than the number calculated using this simplified procedure. Dividends reduce the value of stock options, because option holders don't receive dividends until after the exercise the option and hold the shares.

If your company pays dividends, it makes sense to reduce the values calculated by the shortcut methods described above. There are a number of stock option value calculators on the Internet. Some are no good at all, but some are excellent — and free.

My favorite is offered by IVolatility. Read our explanation first, then go to this page and look for a link to their Basic Calculator. Start out by entering the symbol for your company's stock in the box for "symbol.

Ignore the box for "style" because that doesn't matter for this type of option. Time spreads in options refer to the creation of a spread involving the sale of an option in one expiration cycle and the purchase of an option in another expiration cycle. They have the same strike price and are either all calls or all puts. They are also referred to as calendar spreads or horizontal spreads, as in time horizon. They are not to be confused with futures time spreads that have nothing to do with strike price.

I refer to them as time value spreads. Relative time value is what the spreads are all about.

BREAKING DOWN 'Time Value'

The price of an option, otherwise known as the premium, has two basic components: intrinsic value and time value. Trading Understanding Option Pricing. Option Price - Intrinsic Value = Time Value For example, if Company XYZ is trading for $25 and the XYZ 20 call option is trading at $7, then we would say that the option has an intrinsic value of $5 ($25 - $20 = $5), and a time value of $2 ($7 - $5 = $2). Time spreads in options refer to the creation of a spread involving the sale of an option in one expiration cycle and the purchase of an option in another expiration cycle. They have the same strike price and are either all calls or all puts.