Option Time

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The Importance of Time Value in Options Trading

Most investors and traders new to options markets prefer to buy calls and puts because of their limited risk and unlimited profit potential. Buying puts or calls is typically a way for investors and traders to speculate with only a fraction of their capital. But these straight option buyers miss many of the best features of stock and commodity options, such as the opportunity to turn time-value decay (the reduction in value of an options contract as it reaches its expiration date) into potential profits.

When establishing a position, option sellers collect time-value premiums paid by option buyers. Rather than losing out because of time decay, the option seller can benefit from the passage of time, and time-value decay becomes money in the bank even if the underlying asset is stationary.

Before explaining the importance of time value with respect to option pricing, this article takes a detailed look at the phenomenon of time value and time-value decay. First we’ll look at some basic option concepts that apply to the concept of time value.

Options and Strike Price

Depending on where the underlying asset is in relation to the option strike price, the option can be in, out, or at the money. At the money means the strike price of the option is equal to the current price of the underlying stock or commodity. When the price of a commodity or stock is the same as the strike price (also known as the exercise price) it has zero intrinsic value, but it also has the maximum level of time value compared to that of all the other option strike prices for the same month. The table below provides a table of possible positions of the underlying asset in relation to an option’s strike price.

The Relationship of the Underlying to the Strike Price
Put Call
In-the-money option The price of the underlying is less than the strike price of the option. The price of the underlying is greater than the strike price of the option.
Out-of-the-money option The price of the underlying is greater than the strike price of the option. The price of the underlying is less than the strike price of the option.
At-the-money option The price of the underlying is equal to the strike price of the option. The price of the underlying is equal to the strike price of the option.

Note: Underlying refers to the asset (i.e. stock or commodity) upon which an option trades.

This table shows that when a put option is in the money, the underlying price is less than the option strike price. For a call option, in the money means that the underlying price is greater than the option strike price. For example, if we have an S&P 500 call with a strike price of 1,100 (an example we will use to illustrate time value below), and if the underlying stock index at expiration closes at 1,150, the option will have expired 50 points in the money (1,150 – 1,100 = 50).

In the case of a put option at the same strike price of 1100 and the underlying asset at 1050, the option at expiration also would be 50 points in the money (1,100 – 1,050 = 50). For out-of-the-money options, the reverse applies. That is, to be out of the money, the put’s strike would be less than the underlying price, and the call’s strike would be greater than the underlying price. Finally, both put and call options would be at the money when the underlying asset expires at the strike price. While we are referring here to the position of the option at expiration, the same rules apply at any time before the options expire.

Time Value of Money

With these basic relationships in mind, we take a closer look at time value and the rate of time-value decay (represented by theta, from the Greek alphabet). If we ignore volatility, for now, the time-value component of an option, also known as extrinsic value, is a function of two variables: (1) time remaining until expiration and (2) the closeness of the option strike price to the money. All other things remaining the same (or no changes in the underlying asset and volatility levels), the longer the time to expiration, the more value the option will have in the form of time value.

But this level is also affected by how close to the money the option is. For example, two call options with the same calendar month expiration (both having the same time remaining in the contract life) but different strike prices will have different levels of extrinsic value (time value). This is because one will be closer to the money than the other.

The table below illustrates this concept and indicates when time value would be higher or lower and whether there will be any intrinsic value (which arises when the option gets in the money) in the price of the option. As the table 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. Time value is at its highest level when an option is at the money because the potential for intrinsic value to begin to rise is greatest at this point.

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Intrinsic Value vs. Time Value
In-the-money Out-of-the money At-the-money
Put/Call Time-value decreases as the option gets deeper in the money; intrinsic value increases. Time-value decreases as option gets deeper out of the money; intrinsic value is zero. Time-value is at a maximum when an option is at the money; intrinsic value is zero.

Note: Intrinsic value arises when an option gets in the money.

Time-Value Decay

In the figure below, we simulate time-value decay using three at-the-money S&P 500 call options, all with the same strikes but different contract expiration dates. This should make the above concepts more tangible. Through this presentation, we are making the assumption (for simplification) that implied volatility levels remain unchanged and the underlying asset is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer.

Taking our series of S&P 500 call options, all with an at-the-money strike price of 1,100, we can simulate how time value influences an option’s price. Assume the date is February 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates (February, March, and April), the phenomenon of time-value decay becomes evident. We can witness how the passage of time changes the value of the options.

The figure below illustrates the premium for these at-the-money S&P 500 call options with the same strikes. With the underlying asset stationary, the February call option has five days remaining until expiry, the March call option has 33 days remaining, and the April call option has 68 days remaining.

As the figure below shows, the highest premium is at the 68-day interval (remember prices are from February 8), declining from there as we move to the options that are closer to expiration (33 days and five days). Again, we are simply taking different prices at one point in time for an at-the-option strike (1100), and comparing them. The fewer days remaining translates into less time value. As you can see, the option premium declines from $38.90 to $25.70 when we move from the strike 68 days out to the strike that is only 33 days out.

The next level of the premium, a decline of 14.7 points to $11, reflects just five days remaining before expiration for that particular option. During the last five days of that option, if it remains out of the money (the S&P 500 stock index below 1,100 at expiration), the option value will fall to zero, and this will take place in just five days. Each point is worth $250 on an S&P 500 option.

One important dynamic of time-value decay is that the rate is not constant. As expiration nears, the rate of time-value decay (theta) increases (not shown here). This means that the amount of time premium disappearing from the option’s price per day is greater with each passing day.

The concept is looked at in another way in the figure below: The number of days required for a $1 (1 point) decline in premium on the option will decrease as expiry nears.

This shows that at 68 days remaining until expiration, a $1 decline in premium takes 1.75 days. But at just 33 days remaining until expiration, the time required for a $1 loss in premium has fallen to 1.28 days. In the last month of the life of an option, theta increases sharply, and the days required for a 1-point decline in premium falls rapidly.

At five days remaining until expiration, the option is losing 1 point in just less than half a day (0.45 days). If we look again at the Time-Value Decay figure, at five days remaining until expiration, this at-the-money S&P 500 call option has 11 points in premium. This means that the premium will decline by approximately 2.2 points per day. Of course, the rate increases even more in the final day of trading, which we do not show here.

The Bottom Line

While there are other pricing dimensions (such as delta, gamma, and implied volatility), a look at time-value decay is helpful to understand how options are priced.

Expiration Time

What is Expiration Time?

The expiration time of an options contract is the date and time when it is rendered null and void. It is more specific than the expiration date and should not be confused with the last time to trade that option.

Key Takeaways

  • The expiration time of an options contract is the date and time when it is rendered null and void.
  • Typically, the last day to trade an option is the third Friday of the expiration month, but the actual expiration time is not until the next day (Saturday).

Understanding Expiration Time

Expiration time differs from the expiration date in that the former is when the option actually expires while the latter is the deadline for the holder of the option to make their intentions known. Most option traders need only be concerned with the expiration date but it is useful to know the expiration time as well.

The NASDAQ offers a more detailed definition: “The expiration time is the time of day by which all exercise notices must be received on the expiration date. Technically, the expiration time is currently 11:59 am Eastern time on the expiration date, but public holders of option contracts must indicate their desire to exercise no later than 5:30 pm on the business day which precedes the expiration date.”

Since many public holders of options deal with brokers, they face different expiration times. Typically, the last day to trade an option is the third Friday of the expiration month, but the actual expiration time is not until the next day (Saturday). A public holder of an option usually must declare their notice to exercise by 5:00 p.m. (or 5:30 p.m. according to NASDAQ) on Friday. This time-frame will allow the broker to notify the exchange of the holders intent by the actual expiration time on the expiration date. Furthermore, notification limits depend on the exchange where the product trades. For example, the Chicago Board Options Exchange (CBOE) limits trading on expiring options to 3:00 p.m. Eastern on the last trading day.

An expiration date in derivatives is the last day that an options or futures contract is valid. When investors buy options, the contracts give them the right, but not the obligation, to buy or sell the assets at a predetermined price. This price is the strike price. The exercising of the option must be within a given period, which is on or before the expiration date. If an investor chooses not to exercise that right, the option expires and becomes worthless, and the investor loses the money paid to buy it.

The expiration date for listed stock options in the United States is usually the third Friday of the contract month, which is the month when the contract expires. However, when that Friday falls on a holiday, the expiration date is on the Thursday immediately before the third Friday. Once an options or futures contract passes the expiration date, the contract is invalid. The last day to trade equity options is the Friday before expiry.

Caveats at Expiration

While the majority of options never reach their expiration dates due to traders offsetting or closing their positions before that time, some options do live on until their actual expiration times. This delay can create interesting dynamics because the last time for trading can be before the expiration time. This time difference is not a problem when the underlying security also closes for trading at the same time.

However, if the underlying security does trade beyond the close of trading for the option, both buyers and sellers might find that the exercise of their contract is automatic if they were in the money. Conversely, they may expect the automatic exercise, but after-hours trading in the underlying asset may push them out of the money.

Rules covering these possibilities, especially at what time the final price of the underlying is recorded, can change. So, traders should check with both the exchange where their options trade, as well as the brokerage handling their account.

Time Value Definition

What Is Time Value?

In options trading, 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 time value. The total premium of an option is equal to the intrinsic value plus the option’s time value.

Time value is also known as extrinsic value.

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 (for example, the stock or commodity or whatever the option is being taken out on) 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; the intrinsic value for a put option (the right to sell an asset) is equal to the strike price minus the underlying price. So, an option’s time value is equal to its premium (the cost of the option) minus its intrinsic value (the difference between the strike price and the price of the underlying asset).

As an equation, time value might be expressed as:

  • Option Premium – Intrinsic Value = Time Value

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. (GOOG) 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).

Key Takeaways

  • Time value is one of two key components that comprise an option’s premium, or price.
  • As an equation, time value is expressed as Option Premium – Intrinsic Value = Time Value.
  • Generally, the more time that remains until the option expires, the greater the time value of the option.

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 become profitable due to 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.

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.

Along with the countdown to expiration, another factor can influence an option’s time value – implied volatility, or the amount an underlying asset is likely to move over a specified time period. If the implied volatility increases, the time value will also rise. For example, if an investor purchases a call option with an annualized implied volatility of 30 percent and the implied volatility jumps to 45 percent the next day, the option’s time value would increase. Investors would figure that dramatic moves bode well for their chances for the asset to move their way.

Whatever the influences, an option’s time value eventually decays to zero at its expiration date.

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