Understanding Options Time Value: A Beginner’s Guide to Trading
Beginners in options trading must comprehend time value. Option contracts provide the buyer the right but not the obligation to acquire or sell an asset at a defined price and time. Time value is the increased value to an option premium owing to the remaining time till expiry.
Premium option
Before studying option time value, you must comprehend the option premium. The buyer pays the seller the option premium for option contract rights. It depends on the underlying asset price, strike price, expiry period, market volatility, and interest rates.
Comparing Time and Intrinsic Value
Time and intrinsic value may be assigned to options. How much the option is in-the-money is intrinsic value. Call options are the difference between the underlying asset’s current price and the strike price. It is the gap between the strike price and the current asset price for put options.
However, time value is the option premium over its inherent value. It indicates the market’s prediction of underlying asset price fluctuations before the option expires. More time till expiry increases option time value.
Declining Time Value
Time value is essential since it degrades. At expiry, the option’s time value decreases to zero. Many call this time decay or theta decay. The time value component makes options more costly the longer they have until expiry.
Options traders must comprehend time decay. If all other circumstances stay constant, an option’s value will drop with time. As expiry approaches, degradation accelerates. Time decay affects option value, therefore traders must include it into their tactics.
Influences on Time Value
Several variables affect option time value, including:
Time till expiration: As indicated, the option’s time value increases with time.
Volatility: Higher volatility increases asset price uncertainty, increasing time value.
Higher interest rates enhance the time value of an option owing to the opportunity cost of tying up funds in the transaction.
Conclusion
Trading novices must understand option time value to make educated judgments. Option holders may lose money when the time value component drops near expiry. Consider time decay while trading options and apply it into your approach.
Sources and References:
Investopedia – https://www.investopedia.com/terms/o/option.asp
The Balance – https://www.thebalance.com/time-value-of-an-option-2536804