A trader generally prefers to trade in calls and puts as they have a very limited amount of risk associated with them and have the ability to earn higher profits. They can use some part of their capital in speculating and getting a high profit.
But many times traders miss a great opportunity to turn time value decay, that is a reduction in the value of an option contract when it is about to expire, this is the time where a trader can get a potential profit.
You must learn about the importance of time value in options. But first, we need to understand some basic factors to move forward.
If we consider the relationship of the underlying asset with that of the strike price, we can get options like ITM (In-The-Money), OTM (Out-Of-Money), and ATM (At-The-Money). In this situation, the money understands the current price of the stock and the stock’s strike price as the same or equal.
We will check the different scenarios for the call and put options during the specific time.
Kindly refer to the below table to understand the relationship of the underlying assets and the stock’s strike price.
Time value in options:
You must keep the above-mentioned basics in mind and we shall now see the time value and decay in the time value, (Here, Theta (Greek alphabet) represents Decay). Consider ignoring the Volatility for some time and taking into consideration the two variables of time: 1. the time we have till the expiration and 2. How near the strike price is and the current price? (considering all other things remaining the same) the longer the time in expiry, the more the option will have time value.
The time value of options can be said as the reason behind the trading of an option at a considerable amount of closing and selling of the shares or contracts. It can also be assumed as the insurance premium the seller requires to provide to the buyer till the date of expiry. Now you need to understand how you can calculate the time value of an option.
The time value of the option formula is as follows:
Time value = Option price - Intrinsic value
Let us say there is a company ABC. It started a trade of $25. The call option of ABC is traded at $7. So to find the intrinsic value, all we need to do is find the difference. So, $25 - $20 = $5. So, to find the time value, we need to find the difference between call option trade price and intrinsic value. So, $7 - $5 = $2.
Note: Those options that have o intrinsic value have complete-time value.
Several factors play a major role in determining the time value of an option.
For instance, the Black Scholes option pricing method takes into consideration five different factors: the current price of the underlying asset, the strike price of the option, standard deviation, expiry time, and risk-free rate.
Option time value calculator
Now, as we all know there are various calculators available online, you may also find option time value calculators online to check out the various factors such as call option, put option, theta value, gamma value, and many more.
Importance of time value in options trading:
We have seen the formulas, and various methods of option pricing, Let us make it simple for you. If there is more time in the expiry of a particular option, it has more time value. An investor will pay more premium, as he has enough time till the expiry and can earn favorable profit from the underlying asset in that particular time.
So, we have seen the basic things to keep in mind while considering the time value in options trading, how to calculate time value of an option, also how to use option time value calculator and what it represents.
On a further note, as the time passes or comes near to the expiry, the time value decreases, and a trader may not gain much profit because of so many other factors affecting such as market volatility.