Options Time Value | Pricing Options

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Time Value

Simply stated, time value is equal to the total premium less the intrinsic value. Time value—sometimes called extrinsic value— reflects the amount of money buyers are willing to pay in expectation that an option will be worth exercising at or before expiration. One of the components of time value reflects the amount of time remaining until the option expires. For example, let’s say that on a particular day in mid-May the November soybean futures price is quoted at $6.30. Calls with a strike price of $6.50 on November soybean futures are trading at a price of 12 cents per bushel. The option is out of the money and therefore, has no intrinsic value. Even so, the call option has a time value of 12 cents (i.e., the option’s premium––its extrinsic value) and a buyer may be willing to pay 12 cents for the option. Why? Because the option still has five months to go before it expires in October, and, during that time, you hope that the underlying futures price will rise above the $6.50 strike price. If it were to climb above $6.62 (strike price of $6.50 + $.12 premium), the holder of the option would realize a profit. At this point in the discussion, it should be apparent why at expiration an option’s premium will consist only of intrinsic value. Such an option would no longer have time value—for the simple reason that there is no longer time remaining. Let’s go back to the out-of-the-money call, which, five months prior to expiration, commanded a premium of 12 cents per bushel. The next question is why 12 cents? Why not 10 cents? Or 30 cents? In other words, what are the factors that influence an option’s time value? While interest rates and the relationship between the underlying futures price and the option strike price affect time value, the two primary factors affecting time value are:

The length of time remaining until expiration.

The volatility of the underlying futures price.

Time_Value_Graph

Length of Time Remaining Until Expiration

All else remaining equal, the more time an option has until expiration, the higher its premium. Time value is usually expressed in the number of days until expiration. This is because it has more time to increase in value (to employ an analogy, it’s safer to say it will rain within the next five days than to say it will rain within the next two days). Again, assuming all else remains the same, an option’s time value will decline (erode) as the option approaches expiration. This is why options are sometimes described as “decaying assets.” As the above chart shows, an option at expiration will have zero time value (its only value, if any, will be its intrinsic value). Also note that the rate of decay increases as you approach expiration. In other words, as the option approaches expiration, the option buyer loses a larger amount of time value each day. Therefore, hedgers, who buy options, may want to consider offsetting their long option position prior to the heavy time value decay and replace it with another risk management position in the cash, futures or option market.

Volatility of the Underlying Futures Price

All else remaining the same, option premiums are generally higher during periods when the underlying futures prices are volatile. There is more price risk involved with market volatility and therefore a greater need for price protection. The cost of the price insurance associated with options is greater, and thus the premiums will be higher. Given that an option may increase in value when futures prices are more volatile, buyers will be willing to pay more for the option. And, because an option is more likely to become worthwhile to exercise when prices are volatile, sellers require higher premiums. Thus, an option with 90 days to expiration might command a higher premium in a volatile market than an option with 120 days to expiration in a stable market.

Other Factors Affecting Time Value

Option premiums also are influenced by the relationship between the underlying futures price and the option strike price. All else being equal (such as volatility and length of time to expiration), an at-the-money option will have more time value than an out-of-the-money option. For example, assume the soybean oil futures price is 24 cents per pound. A call with a 24-cent strike price (an at-the-money call) will command a higher premium than an otherwise identical call with a 26-cent strike price. Buyers, for instance, might be willing to pay 2 cents for the at-the-money call, but only 1.5 cents for the out-of-the-money call. The reason is that the at-the-money call stands a much better chance of eventually moving in the money. An at-the-money option is also likely to have more time value than an option that is substantially in the money (referred to as a deep in-the-money option). One of the attractions of trading options is “leverage”—the ability to control relatively large resources with a relatively small investment. An option will not trade for less than its intrinsic value, so when an option is in-the-money, buyers generally will have to pay over and above its intrinsic value for the option rights. A deep in-the-money option requires a greater investment and compromises the leverage associated with the option. Therefore, the time value of the option erodes. Generally, for a given time to expiration, the greater an option’s intrinsic value, the less time value it is likely to have. At some point, a deep in-the-money option may have no time value— even though there is still time remaining until expiration. Another factor influencing time value is interest rates. Although the effect is minimal, it is important to realize that as interest rates increase, time value decreases. The opposite is also true— as interest rates decrease, time value increases.

This information has been provided with permission by the Chicago Board of Trade from their original publication:
Agricultural Futures and Options: A Hedger’s Self-Study Guide.

Click here to receive the entire publication.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations. EM11-3R1 07.04.10000 04-03597