The “time value” of an option is the extrinsic value of an option.
The term “time value” is an informal way of saying the more accurate name of “extrinsic value.”
While it is true that “time value” is based on how much time is left till expiration.
It is not just “time”.
The implied volatility of the option is also factored into the extrinsic value.
Contents
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- Introduction
- What Is The Intrinsic Value Of A Put Option?
- What Is The Intrinsic Value Of A Call Option?
- What Is Extrinsic Value?
- Are The Time Value Of LEAPS Calculated In The Same Way?
- Summary
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Introduction
Before explaining what that means, let’s start with the basics.
There are two types of options contracts: put options and call options.
The value of an option is what an investor or a trader is willing to pay for that option.
The value of an option is further subdivided into intrinsic value and extrinsic value.
Some options have intrinsic and extrinsic values, whose sum is the option’s value.
Some options have no intrinsic value and only have extrinsic value.
In general (but not always), the extrinsic value of an option decreases as the option gets closer to expiration.
At expiration, the extrinsic value will always be zero.
If an option has intrinsic value left at expiration, that value is automatically converted into real cash or stock, and then the option disappears.
If a put option has intrinsic value at expiration, the holder can exercise it (most brokers will automatically exercise it for you).
That means that the stock you own will be sold at the option’s strike price.
If you don’t own any such stock, then you will get cash as if you purchased the stock at market price and then sold it at strike price.
If a put option has intrinsic value, this will be to your benefit, and you will get cashback.
This is because a put option can only have intrinsic value if its strike price is above the underlying stock’s market price.
This condition is when the option is “in-the-money”.
Similarly, a call option has intrinsic value if the underlying stock’s price is higher than the strike price.
The owner of a call option with intrinsic value at expiration will exercise (or the broker will automatically exercise) that option to buy the stock at the strike price.
This benefits the owner because they buy stock at a lower market price.
Then, that in-the-money call option is converted into stock, and the option disappears.
If the owner no longer wants this stock, he can then immediately sell that stock at market price if he or she wishes to do so.
It is always important that automatic exercise (in both cases) is financially beneficial to the owner of the option that is being exercised.
What Is The Intrinsic Value Of A Put Option?
The intrinsic value is calculated as the difference between the underlying stock’s price and the strike price.
You can think of intrinsic value as the “real tangible value” of an option.
In the case of the put option
Intrinsic value of put option = strike price of put option – market price of the stock
What is the intrinsic value of an NVDA put option with a strike price of $140 when the NVDA stock price is at $138?
Answer is $2.
This NVDA put option is “in the money.”
What is the intrinsic value of an NVDA put option with a strike price of $130 when the NVDA stock price is at $138?
The answer is zero.
This NVDA put option is “out-of-the-money.”
What Is The Intrinsic Value Of A Call Option?
In the case of the call option:
Intrinsic value of call option = market price of the stock − strike price of the call option
What is the intrinsic value of the TSLA call option with a strike price of $210 when the TSLA stock price is at $220?
Answer is $10.
This TSLA call option is “in-the-money” by $10.
What is the intrinsic value of a TSLA call option with a strike price of $230 when the TSLA stock price is at $220?
The answer is zero.
This TSLA call option is “out-of-the-money.”
What Is Extrinsic Value?
An option’s extrinsic value, or the time value, is the option value minus its intrinsic value.
What is the extrinsic value of an NVDA put option with a strike price of $140 when the NVDA stock price is at $138?
Okay, not enough information.
Further, assume that this put option has 27 days till expiration and the put option is trading at $7.90 (on a per-share basis).
Answer: We saw previously that the intrinsic value is $2.
So the extrinsic value is $7.90 – $2 = $5.90.
What is the extrinsic value of an NVDA put option with a strike price of $130 when the NVDA stock price is at $138?
Assume that the $130 put option is trading at $3.70.
The answer is that the extrinsic value is $3.70 because this “out-of-the-money” put option has no intrinsic value.
What is the extrinsic value of the TSLA call option with a strike price of $210 when the TSLA stock price is at $220?
Assume that the $210 call option is trading at $14.50.
The answer is that the extrinsic value is $4.50 for this call option, which is in the money by $10.
What is the extrinsic value of the TSLA call option with a strike price of $230 when the TSLA stock price is at $220?
Assume that the $230 call option is trading at $4.50.
Then, the extrinsic value is $4.50 since this option is out-of-the-money.
Are The Time Value Of LEAPS Calculated In The Same Way?
Yes, they are.
LEAPS (Long-term Equity Anticipation Securities) are options contracts with longer expiration periods, typically one year or more.
They are no different from typical options other than their longer-dated expiration dates.
Therefore, everything about intrinsic value and extrinsic value applies.
The time value is calculated the same way.
Summary
I hope I didn’t make this article sound too complicated.
Maybe I could have simply said:
Time value = extrinsic value
Extrinsic value = option value – intrinsic value
In the case of “out-of-the-money” options, they have no intrinsic value, so…
Extrinsic value = option value.
We hope you enjoyed this article on how to calculate the time value of an option.
If you have any questions, send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Original source: https://optionstradingiq.com/how-to-calculate-the-time-value-of-an-option/
