Option time value


Option time value

In finance, the time value (TV) (extrinsic or instrumental value) of an option is the premium a rational investor would pay over its current exercise value (intrinsic 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.[1] 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.[2]

Contents

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.[3]

Value of a call option: max[(SK),0], or (SK) +
Value of a put option: max[(KS),0], or (KS) +

As seen on the graph, the IV of a call option is positive when the underlying asset's spot price S exceeds the option's strike price K.

Option value

Option Value

Option value (i.e. price) is estimated via a predictive formula 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.[4]

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.[5] An important factor is the option's volatility. Volatile prices of the underlying instrument can stimulate option demand, enhancing the value. Numerically, this value depends on the time until the expiration date and the volatility 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.[6]

See also

References

  1. ^ Note, however, that there is also a cost component of holding an option (or any asset), based on the time value of money.
  2. ^ Understanding Option Pricing Hans Wagner
  3. ^ Understanding Option Pricing Hans Wagner
  4. ^ Note that the X axis is not time — the graph represents the relationship between price and value at a particular time. With more time left to expiration, the red curve would be higher; the closer to expiration, the more it would approach the blue intrinsic value line.
  5. ^ Option premium valuation 22 August 2007
  6. ^ Options: Time Value, wolfram.com

External links and references

External links



Wikimedia Foundation. 2010.

Look at other dictionaries:

  • Time value of money — The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory. For example, $100 of today s money invested for one year… …   Wikipedia

  • time value — The amount of money option buyer are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and …   Financial and business terms

  • Time value of an option — The portion of an option s premium that is based on the amount of time remaining until the expiration date of the option contract, and that the underlying components that determine the value of the option may change during that time. Time value… …   Financial and business terms

  • time value — The market value of an option over and above its intrinsic value, representing the value of the possibility that the price of the underlying will shift significantly in a favourable direction before the option expires. Clearly, this value… …   Big dictionary of business and management

  • time value of an option — The portion of an option s premium that is based on the amount of time remaining until the expiration date of the options contract, and the idea that the underlying components that determine the value of the option may change during that time.… …   Financial and business terms

  • Time Value — The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Basically, time value is the value the option has in addition to its intrinsic value …   Investment dictionary

  • Time value — In finance, time value is:* Time value of money; or * Time value of an option.In transport economics, time value refers to:* Value of time …   Wikipedia

  • Time value of an option —   The difference between the intrinsic value of an option and the prevailing market price for that option …   International financial encyclopaedia

  • time value premium — The amount by which an option s total premium exceeds its intrinsic value. Bloomberg Financial Dictionary …   Financial and business terms

  • Option style — In finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) …   Wikipedia


Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”

We are using cookies for the best presentation of our site. Continuing to use this site, you agree with this.