Knowing the importance of time value
What is time value?
Time value is a premium option attributed to the time left before the option contract expires. It is made up of two components, and they are intrinsic and extrinsic value. Extrinsic value refers to the difference between the premium and intrinsic value. On the other hand, intrinsic value refers to the inherent worth of an option.
The components of options are time value and extrinsic value. Options are relative to the derivatives market. We mentioned time value, and you should note that it is not the same as TVM or the time value of money. TMV tells us the discounting of money's purchasing power in the long run.
Time value, intrinsic value, and total premium
How much does an option costs? This amount of money is what we call the premium, and a buyer gives this to the option seller for a right that an option can provide. What is this right? It is the right to buy or sell the asset. It can also be the right to let it expire without value.
We already mentioned earlier that the intrinsic value is the difference between the option's strike price and the underlying asset's price. Let us be more specific. The intrinsic value of a call option offers a right to buy an asset but not an obligation. It should be the same with the difference between the underlying price and the strike price. On the other hand, the intrinsic value for a put option gives a person the right to sell an asset but is not obliged to. It should be the same as the difference between the strike price and the underlying price.
Options have premiums, and they depend on their intrinsic and extrinsic value. And when we say extrinsic value, know that it always comes with a time value, which is a significant factor. Usually, we know that a contract will most likely lose its value as it reaches its expiration date. Why? Because it gets a lesser chance to have more favorable movements as it is out of time. Let us say that we have two out-of-money options. One is about to expire in a month, and the other will expire in a week. Which among the two has more extrinsic value based on what we just explained? It is the one with one more month until it expires. Hence, the more time an option has until it expires, the more time value it has because it can become more profitable.
Aside from extrinsic value, we also have implied volatility. It measures how much more movements an underlying asset may have in a given time frame. More implied volatility means more extrinsic value.
Let us calculate the time value.
Time value + Implied volatility = Option premium - Intrinsic value
This is an equation that can express time value. If we put it in words, we can say that time value equals the premium amount that we get as excess from the intrinsic value.
How significant is time value?
It is simple. If an option has more time, then it has more value. In a nutshell, investors are willing to pay more premium if the contract has more time because then, it will have more time to be profitable. Hence, the less time the option has, the more hesitation investors will have in buying it because it has a more minimal chance of becoming more profitable. This is why most think it is safer to sell or hold options when they still have time left instead of exercising them. Because if they do, the remaining time value will be gone soon.
