Time value definition

In options trading, time value refers to the portion of an option’s premium that is ascribable to the amount of time remaining until it expires. Time value is part of an option’s extrinsic value, along with implied volatility. This should not be confused with the time value of money – this describes how the same sum of money is worth more now than the same sum in the future.

An option’s total premium is based on its extrinsic and intrinsic value. Normally, a contract loses its value when it nears its expiration date because there is less time for the underlying asset to move in a favourable direction. In other words, an option that is one month to expiration will have more extrinsic value than an option with one week to expiration.

How to calculate time value

Time value can be calculated as:

Time value = Option premium – Intrinsic value

For instance, if a trader purchases an option with a strike price of 200 and a premium of $150 and an intrinsic value of 100, then the time value would be $50.

Significance of time value

Overall, the more time until expiry, the greater the option’s time value. This is because investors are willing to pay a higher premium for more time, as the contract will have longer to profit from favourable moves.

This means when there is less time remaining on an option, investors are not willing to pay as much for the premium, as there is less chance for the option to become profitable. Due to this, it is considered safer to either hold or sell an option that still has time value, instead of exercising it right away.

Generally, an option loses one-third of its time value during the first half of its life and loses the remaining two-thirds during the second half of its life. Time value is noted to drop at an accelerating pace, something which is known as time decay. The sensitivity of an option’s price regarding its time decay is called its theta.

Traders should understand the time value of options as well as their intrinsic value because they can use it to determine an option’s potential profitability as well as the risk involved. It also helps traders identify what strategy is appropriate to use, such as whether they should hold the option until expiration or close the position before it expires.

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