In
finance"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, the
time value (TV) (
extrinsic or
instrumental value) of an
optionIn finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
is the premium a rational investor would pay over its
current exercise value (
intrinsic valueIn finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value...
), based on its potential to increase in value before expiring. This probability is always greater than zero, thus an option is
always worth more than its current exercise value. As an option can be thought of as ‘price insurance’ (e.g. an airline insuring against unexpected soaring fuel costs caused by a hurricane),
TV can be thought of as the
risk premium the option seller charges the buyer — the higher the expected risk (volatility • time), the higher the premium. Conversely,
TV can be thought of as the price an investor is willing to pay for potential upside.
TV decays exponentially to zero at expiration, with a general rule that it will lose ⅓ of its value during the first half of its life and ⅔ in the second half. As an option moves closer to expiry, moving its price requires an increasingly larger move in the price of the underlying security.
Intrinsic value
The
intrinsic value (IV) of an option is the value of exercising it now. If the option has a positive monetary value, it is referred to as being in-the-money, otherwise it is referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder will simply abandon the option and it will expire worthless. Because no rational investor would choose to exercise out-of-the-money,
an option can never have a negative value.
- Value of a call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
: 
, or 
- Value of a put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
: 
, or 
As seen on the graph, the
IV of a call option is positive when the underlying asset's
spot priceThe spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
S exceeds the option's
strike priceIn options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
K.
Option value
Option value (i.e. price) is estimated via a predictive
formulaIn mathematics, a formula is an entity constructed using the symbols and formation rules of a given logical language....
such as Black-Scholes or using a numerical method such as the Binomial model. This price incorporates the expected probability of the option finishing "in-the-money". For an out-of-the-money option, the further in the future the expiration date - i.e. the longer the time to exercise - the higher the chance of this occurring, and thus the higher the option price; for an in-the-money option the chance of being in the money
decreases; however the fact that the option cannot have negative value also works in the owner's favor. The sensitivity of the option value to the amount of time to expiry is known as the option's theta. The option value will never be lower than its
IV.
As seen on the graph, the full call option value (
IV + TV), at a given time
t, is the red line.
Time value
Time value is, as above, the difference between option value and intrinsic value, i.e.
Time Value = Option Value - Intrinsic Value.
More specifically,
TV reflects the probability that the option will gain in
IV — become (more) profitable to exercise before it expires. An important factor is the option's
volatilityIn finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
. Volatile prices of the underlying instrument can stimulate option demand, enhancing the value. Numerically, this value depends on the time until the
expiration dateExpiration date can refer to:*The shelf life of a grocery item*Expiration *Copyright expiration*Expiration Date , a 2006 comedy* Expiration Date, a novel by Tim Powers...
and the
volatilityIn finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
of the underlying instrument's price.
TV cannot be negative (because the option value is never lower than
IV), and converges to zero at expiration. Prior to expiration, the change in
TV with time is non-linear, being a function of the option price.
External links and references
External links