What is the time value of an option?
One of the key components of an options trade is its premium, i.e., the amount of money paid by the buyer to the seller. Its size depends on the level of risk assumed by the seller. In economics, everything is measurable—even risk can be calculated and assigned a precise price. To do this, several models for calculating the premium have been created in the options market, the most popular of which use values such as the intrinsic and time value of the option.
What Is Called the Time Value of an Option?
Two components are used to calculate the premium. Each equally influences the price of the option.
The time value of an option is one of these components. Its size depends on the time remaining until the contract expires. The less time remains, the lower the time value. By the moment the option is exercised, the time value will equal zero.
This indicator reflects the level of risk very well. In a classic American option, early expiration is possible—that is, the holder of the security has the right to convert the contract at any convenient time during its term. The buyer can take advantage of one of the market’s rises or falls and make a good profit without making large investments. The longer the option term, the higher the chances of fluctuations occurring.
In the case of reselling the option to another party, the time value changes its movement trajectory in the opposite direction, especially if the security is currently in the money. The less time until expiration, the higher the chance for the buyer to profit from the purchase.
Other Components of an Option Premium
The second important component of an option's premium is its intrinsic value. There are other factors that influence the premium, but they are rarely taken into account.
Intrinsic value is the difference between the strike price and the spot (current market) price of the underlying asset.
Call and put options have different calculation methods. For put options, the strike price is subtracted from the market price; for calls—vice versa.
If the market price and strike price are equal, the intrinsic value is calculated as zero, but this is quite rare. In most cases, the participants calculate the average market price over a past time period equal to the duration of the option. For example, if the option is valid for a week, its strike price will equal the average price of the underlying asset over the past week.
If the average price differs from the spot price on the date of the deal, it means the price either fell sharply or rose sharply during that period. The same volatility may occur during the option's term, which means one of the parties (which one depends on whether the intrinsic value is positive or negative and the type of security used) takes on increased risk.
Calculating Option Premium by Time Value
In the case of exchange-traded options, this calculation is extremely simple because the algorithm for determining time value is handled by the exchange itself.
In over-the-counter (OTC) deals, the level of time value is calculated as a percentage. For example, the seller may set the payment for each month of the option's validity at 3% of the total investment amount.
Still, intrinsic and time value are not mandatory parameters for calculating the premium—sometimes they aren’t used at all. In some cases, the premium depends solely on the buyer, as in binary options, or is determined as a percentage of the strike price of one unit multiplied by the quantity of the underlying asset.