In finance, the time value of an option is the premium a rational investor would pay over its current exercise value, based on the probability it will increase in value before expiry. For an American option this value is always greater than zero in a fair market, thus an option is always worth more than its current exercise value.. As an option can be thought of as 'price insurance', TV can be thought of as the risk premium the option seller charges the buyer—the higher the expected risk, the higher the premium. Conversely, TV can be thought of as the price an investor is willing to pay for potential upside. TV decays to zero atexpiration, with a general rule that it will lose of its value during the first half of its life and 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 of an option is the value of exercising it now. If the price of the underlying stock is above a call optionstrike price, the option has a positive monetary value, and is referred to as being in-the-money. If the underlying stock is priced cheaper than the call option's strike price, the call option is referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder simply abandons the option and it expires worthless. Hence, a purchased option can never have a negative value. This is because a rational investor would choose to buy the underlying stock at market rather than exercise an out-of-the-money call option to buy the same stock at a higher-than-market price. For the same reasons, a put option is in-the-money if it allows the purchase of the underlying at a market price below the strike price of the put option. A put option is out-of-the-money if the underlying's spot price is higher than the strike price. As shown in the below equations and graph, the intrinsic value 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 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 moneydecreases; 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, 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. More specifically, TVreflects the probability that the option will gain in IV — become profitable to exercise before it expires. 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 of American option cannot be negative, 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.
