You are already familiar with the time value of money and the magic of compound interest. The longer you leave your savings untouched and accruing interest, the more your wealth will grow.
The time value of options is a little different, but it’s equally important to successful investing.
Understanding how time impacts the premium you pay for an option is critical for making smart decisions around this type of investment.
Options: An Overview
Trading options gives you an opportunity to profit from changes in the market without the large cash outlays required when purchasing individual stocks.
Instead, your options contracts gives you the right to buy or sell the stated number of shares for an agreed-upon amount until the option expires. This pre-determined amount is referred to as the strike price.
Note that while you have the right to exercise your options, you aren’t required to do so. On the other hand, the contract writer must honor the terms of your options contract if you choose to exercise your rights.
There are two types of options:
Call options give you the right to purchase an asset or call it away from the current owner.
For example, if QRS shares are currently trading at $45, and you expect the value to increase in coming months, you could purchase a call option to buy shares at $45. If, in fact, shares go up to $55 before your option expires, you can still make the trade at $45.
Put options give you the right to sell an asset or put it to the contract writer for the agreed-upon strike price.
For example, if QRS shares are currently trading at $45, and you expect the value to decrease in coming months, you could purchase a put option to sell shares at $45. If, in fact, shares go down to $35 before your option expires, you can still make the trade at $45.
When you trade options, you pay a premium to the contract writer. If the contract expires without being exercised, your total loss is the premium you paid.
The amount of the premium is based on the level of risk the contract writer takes on by agreeing to buy or sell shares at the contract price. Risk is determined by the time value of options.
Intrinsic Value and Time Value: The Basics of Options Pricing
There are two factors that contribute to the premium amount you pay for an options contract:
- the intrinsic value
- the time value
The intrinsic value of an option is the difference between the current price of the underlying shares and the options strike price.
For example, if you hold a call option for 100 shares of QRS at $45 per share, and QRS shares are currently trading at $55 per share, the intrinsic value of the option is $10 x 100 or $1,000.
If you hold a put option for 100 shares of QRS at $45 per share, and QRS shares are currently trading at $35 per share, the intrinsic value of the option is $10 x 100 or $1,000.
In other words, for call options, Intrinsic Value = Price of Underlying Asset – Strike Price.
For put options, Intrinsic Value = Strike Price – Price of Underlying Asset.
You will notice that options often trade for more than their intrinsic value – and that the more time remaining before the option’s expiration date, the higher the premium.
Investors are willing to pay more when an option’s expiration date is months away, because there is more opportunity for the underlying stock price to change.
Conversely, when options are going to expire in the near future, the premium is quite close to the intrinsic value. There isn’t much time for the underlying stock price to change.
The difference between the intrinsic value and the premium paid is the time value of options.
In other words:
- Time Value = Premium – Intrinsic Value; so
- Premium = Intrinsic Value + Time Value.
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Calculating the Time Value of Options
If you would like to know how much you are paying for the time value of options, start with the underlying stock price. Then, consider the terms of the options contract.
If the underlying stock is trading for less than the strike price of a call option or more than the strike price of a put option, the option is out of the money. The intrinsic price of the option is $0.
If the opposite is true, and the underlying stock is trading for more than the strike price of a call option or less than the strike price of a put option, the option is in the money. The option has intrinsic value, which you can calculate using the formulas above.
Next, have a look at the premium charged for the options contract. Once you subtract the intrinsic value of the option from the premium, the remaining amount is the time value of the option.
For example, a $50 call on QRS has a premium of $6 per share. QRS is currently trading at $55 per share, so the intrinsic value is $5. The time value of the option is $1 per share.
For out of the money options, the entire premium is time value – a calculation of the likelihood that the option will be in the money before it expires.
For in the money options expiring soon, the premium is likely quite close to the intrinsic value of the contract. When there is no time remaining before the expiration date, the option has no time value.
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How To Profit From Time Value of Options
An almost limited number of options trading strategies exist to profit from time-decay, the process by which the time value of options diminishes. The most common is the covered call strategy.
The covered call is created when a shareholder sells a call against their underlying stock position. For example, if you owned 100 shares of Netflix and sold 1 call option, you would create a covered call position.
The reason to sell the covered call is because the shareholder may believe the stock is unlikely to rapidly rise higher but will instead either meander sideways, slightly higher, or even fall slightly.
As time goes by and the expectations of the shareholder are fulfilled, the time value of the call option is steadily eroded – all else being equal.
By the expiration date of the call option, all the time value of the option will be worthless and so, assuming the share price remains below the call strike price, the shareholder enjoys an income equal to the call option premium originally sold.
Covered call traders have to be wary about the share price rising above the call strike price. When that occurs at expiration, the call is assigned automatically upon expiration and the shares are sold.
Other strategies like the bull put spread also profit from time value of options decaying due to theta.
Get Started Trading The Time Value of Options
To being trading and capitalizing from the time value of options, you will want to choose a broker who understands options well.
Some of the best options trading platforms including thinkorswim and tastyworks. Both platforms were built by stock and options traders for stock and options traders, and can cater to basic strategies like covered calls and married puts, as well as more complex multi-legged strategies like iron condors and ratio backspreads.
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If some of this options lingo sounds like double dutch to you, check out this Options Trading For Dummies guide or the best books on options trading.
>> How To Trade A Bull Call Options Spread
>> How To Trade A Bear Call Options Spread
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