Factors determining the Time value of Options

Before you learn the factors that determines the time value of Options, it is important that you understand certain terms.

The Option Premium has 2 parts: The Intrinsic value and the Time Value.

Intrinsic Value — The money value the Option has if it is exercised immediately. It is the difference between the Current Price and Exercise price.

For CALL Options

·         If the Strike Price is less than the Current Price, the intrinsic value is (Current Price – Strike Price).

·         If the Strike Price is more than the Current Price, the intrinsic value is 0.

For PUT Options

·         If the Strike Price is more than the Current Price, the intrinsic value is (Strike Price - Current Price).

·         If the Strike Price is less than the Current Price, the intrinsic value is 0.

Time Value —The part of an option price that is based on its time to expiration. If you subtract the amount of intrinsic value from an Option Premium, you’re left with the time value. If an option has no intrinsic value, the premium is entirely the time value.

The other Terms to understand the impact of time value in Options premium are:

In-The-Money: If you exercise the Option right now and you can get some money, a Option contract is said to be “In the money”.

For CALL options, if the Strike Price is less than the Current Price, the Option is said to be “In the Money”. If a CALL has a strike price of $10 and the stock is currently trading at $12, the option is in-the-money. The amount it is in the money is the difference between the current trading price ($12) and the strike Price ($10) i.e., It is $2 in the money.

On the Similar line, for PUT options, if the Strike Price is more than the Current Price, the Option is said to be “In the Money”. If a PUT has a strike price of $10 and the stock is currently trading at $8.5, the option is in-the-money. The amount it is in the money is the difference between the strike Price ($10)  and the current trading price ($8.5) i.e., It is $1.5 in the money.

Out-of-Money: If you exercise the Option right now and you don’t get any money, a Option contract is said to be “Out of money”. For CALL options, if the current stock price is below the strike price and for PUT options, if the current stock price is above the strike price, it is said to be out of money. The price of out-of-the-money options consists entirely of “time value.”

At-The-Money : If the An option is “at-the-money” when the stock price is equal or nearly equal to the strike price. The strike price to be considered at the money is very subjective since the strike prices are on nominal scale (with gap of $1, $5 etc) but stock price are continuous.

So you can consider, the nearest strike price with the difference of less than 5 % as in the money.

Now see the factors that impact the Time Value in the Option Price:

Time to Expiration:  The farther the time to expiration, the more will the time value of the Option. So for 2 options for the same underlying stock and Strike Price with different expiration date will have different price (premium). The difference in the premium will be because of the time difference and it will go on increasing as the time to expiration increases.

In the above example if you see, the time value of the same strike price ($405) AAPL Option is increasing. This is because in the world of Option, the time is Money and the more time you have to expiration, the more value your option holds. This is because if you have more time to expiration, there is more probability of you hitting the price target.

How deep you are “In the Money” or “Out of Money”:  The farther you are away from the current Stock price, the less will the time value of the Option. So for 2 options for the same underlying stock and the same Expiration Date with different Strike Price, the time value for the Option will have different value. The difference in the premium will be because of the difference in strike price and also because of depth of in the money or out of money.

Let us see the example

Current Price	Strike	Time Value	Absolute risk if stock goes below 360	Risk if the Stock remains at current price = time value	Return if the stock goes to 460	% return
402.74	330	2.26	74.45	2.26	55.55	74.6%
402.74	335	2.61	69.8	2.61	55.2	79.1%
402.74	340	3.01	65.25	3.01	54.75	83.9%
402.74	345	3.51	60.75	3.51	54.25	89.3%
402.74	350	4.21	56.2	4.21	53.8	95.7%
402.74	355	5.01	52.05	5.01	52.95	101.7%
402.74	360	5.66	47.9	5.66	52.1	108.8%
402.74	365	6.76	43.85	6.76	51.15	116.6%
402.74	370	7.81	40	7.81	50	125.0%
402.74	375	9.06	36.3	9.06	48.7	134.2%
402.74	380	10.31	32.7	10.31	47.3	144.6%
402.74	385	12.01	29.3	12.01	45.7	156.0%
402.74	390	13.76	26.1	13.76	43.9	168.2%
402.74	395	15.76	23.1	15.76	41.9	181.4%
402.74	400	17.96	20.4	17.96	39.6	194.1%
402.74	405	17.9	17.75	17.9	37.25	209.9%
402.74	410	15.65	15.4	15.65	34.6	224.7%
402.74	415	13.5	13.3	13.5	31.7	238.3%
402.74	420	11.55	11.35	11.55	28.65	252.4%
402.74	425	9.85	9.65	9.85	25.35	262.7%
402.74	430	8.3	8.05	8.3	21.95	272.7%
402.74	435	7.1	6.85	7.1	18.15	265.0%
402.74	440	5.85	5.75	5.85	14.25	247.8%
402.74	445	4.85	4.75	4.85	10.25	215.8%
402.74	450	4.05	3.95	4.05	6.05	153.2%

In the above example if you see, the time value of the same expiration (Feb 17,2012) AAPL Option is increasing and then decrease. At the time of creating this example, AAPL was trading at $402.74.  You will see that the Time value increases from “Deep in the Money” to “At the Money” and then starts decreasing from “At the Money” to “Out of Money”.

The Reason: The main reason for any trade is to make money. Making money in the Investment world is not only in term of absolute returns but more in terms of “Return on Investment” and the RISK associated with the investment. The person who is buying deep in the money is taking higher risk and also investing bigger sum. So he is willing to pay little for the time value compared to others who are buying the close to money options.