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Time Value & Time Decay

by Dave Foo June 27, 2009 (Author Profile)


Intrinsic value and time value are two of the primary determinants of an option's price. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. The following equations will allow you to calculate the intrinsic value of call and put options:

Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price Time Value = Call Premium - Intrinsic Value

Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current Price Time Value = Put Premium - Intrinsic Value

At the money (ATM) and out of money (OTM) options don't have any intrinsic value because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration. The intrinsic value of an option is not dependent on the time left until expiration. It is simply an option's minimum value; it tells you the minimum amount an option is worth. Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time. In other words, the time value of an option is directly related to how much time an option has until expiration. The more time an option has until expiration, the greater the option's chance of ending up in-the-money. Time value has a snowball effect. If you have ever bought options, you may have noticed that at a certain point close to expiration, the market seems to stop moving anywhere. That's because option prices are exponential-the closer you get to expiration, the more money you're going to lose i f the market doesn't move. On the expiration day, all an option is worth is its intrinsic value. It's either in-the-money, or it isn't.
All options losses time value everyday. This is the most crucial factor and why we sell options instead of buying options because options whether they are ITM, ATM or OTM losses their time value every single day of their contracts. See the graphs below.

Time Decay Illustration

As a options buyer, you are paying for time value and everyday time is working against you, it is a uphill battle, your position not only has to move in the direction you have anticipated it has to move fast.

Options seller on the other hand has time working for him. It is this little advantage and edge that options seller has that permit him to win over and over again. It doesn’t matter where the market go, as long as the options that he sold is OTM by expiration he get to keep the premium since options that is not ITM by expiration losses all value and will be worthless on expiration.

Simple way of calculating the price of the options per day

Look at any stocks or futures options quote from your favorite platform. Calculate the time value of the options.

If the Options is ITM Call Options: Time value = Underlying Stock's Current Price - Call Strike Price
Put Options: Time value = Put Strike Price - Underlying Stock's Current Price

If the Options is ATM or OTM, it has no intrinsic value and it has only time value in it.

Next calculate how many days from expiration is this options. If it is 1st of Jan and the Options expire on the 20th of Jan. It has 20 days before the options expire.

Price Per Day Calculation: Time Value / No of days to expiration

Let say the options has time value of 10 and there is 20 days to expiration. 10/20 and we have 0.5. If all else remain the same. The options will losses 0.5 everyday until the contract expires.

The above will give you a rough guide on how to calculate price per day and run thru some what if scenario although please bear in mind, market constantly changes and the implied volatility and deltas of options changes too.

Another way you can prove to yourself that time value decreases all the time is. Record the following for a period of 60 days

ATM Options that is 60 days from expiration ATM Options that is 50 days from expiration ATM Options that is 40 days from expiration ATM Options that is 30 days from expiration ATM Options that is 20 days from expiration ATM Options that is 10 days from expiration ATM Options that is 1 days from expiration

You will notice that the premium of the ATM 60 days will gradually decrease as it get nearer to expiration. It has once again proven that options losses time value all the time and this give a little edge for options seller that would be assuming that IV remain the same or thereabout. If IV increase dramatically the ATM money will shoot up, but that would be a uphill battle. But as the days goes by time value will depreciate to 0 and there is no doubt about it.






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