What Happens to the Option Time Value As Stock Prices Rise?
The value of time applies to options rather than stocks. Stocks represent equity while options are a security with a limited lifetime. Options are priced based on two components: time value and intrinsic value. The sum of the two represents the option's "premium." Time value decays with the passage of time (among several other factors), while the intrinsic value follows the change in the price of the underlying stock it is associated with. Understanding each concept helps an investor or trader select an option series that more effectively meets his needs.
Other People Are Reading
-
Option Basics -- Calls
-
There are two option types: calls and puts. A call option gives the contract buyer the right -- but not the obligation -- to call away/buy the underlying shares it represents from the contract seller at a stated price anytime before the contract expires. Calls increase in value as the underlying stock price advances. The seller keeps the premium whether or not the contract is exercised.
Option Basics -- Puts
-
Put options are the opposite of calls. They give the contract buyer the right -- but not the obligation -- to put the underlying shares to the contract seller at a predetermined price anytime before a predetermined expiration. Simply stated, they are an insurance policy for the option owner/holder if the stock has a crash. Puts increase in value as the price of the underlying stock declines. As with call options, the put seller keeps the premium.
-
Understanding Intrinsic Value
-
To understand option time value, an option's intrinsic value first needs to be determined. In the case of a call contract whose value goes up as the stock rises, its intrinsic value will always be the value of the stock's share price minus the strike price of the option. The strike price is the price at which the contract is agreed and controlled -- the transaction price of the shares if the contract is exercised.
A call contract struck at $50 will have an intrinsic value of $10 when the stock price is at $60. A contract struck at $50 will have no intrinsic value when the stock price is $50 or below. The intrinsic value of put contracts are valued the opposite way.
Time Value of Options
-
Time value is whatever premium is left after the intrinsic value is removed from the option price. For example, if a call option struck at $50 is currently priced at $7.50 in the market and the stock is priced at $55, the time value for the remaining live of the contract is $2.50. If the stock suddenly declined to $50 or below, the intrinsic value would disappear, but the time value would still remain at $2.50 or so. As the contract approaches expiration, the time value will decay to zero in an accelerated manner.
Components of Time Value
-
Several factors beyond the remaining life of the contract influence time premium in option pricing. The first is the value of that money if placed in a risk-less security such as T-bills for that same period of time until expiration. Volatility of the market and the underlying stock are also factored. This is called implied volatility. Additional adjustments are made for stocks that pay dividends. If an option has little or no expectation of being assigned, it may have almost no time value at all.
-
