The time value of an option is the difference between its premium and its intrinsic value. Time value is the amount option buyers are willing to pay for the possibility that the option may become profitable prior to expiration due to favorable change in the price of the underlying. Thus, it is a payment for the possibility that the intrinsic value might increase prior to the expiry date. The magnitude of the options’ time value reflects the potential of the option to gain intrinsic value during its life. Prior to expiration options will almost have some time value, the exceptions are deep in-the-money European options. When an option is sold, rather than exercised, time value is received in addition to the intrinsic value. Time value cannot be negative. An option loses its time value as its expiration date nears. Time value premium decreases at an accelerated rate as the option approaches maturity. At expiration, an option is worthy only its intrinsic value.
A call that is out of the money or at the money has only time value. Usually the maximum time value exists when the option is at the money.
One of the factors that determine time value is the market expectations of price volatility. If the market expectation of price volatility of an underlying asset is high the time value will also be high, reflecting the strong possibility of a substantial increase in intrinsic value.
Time value premium is maximum when the stock price and the strike price are the same. When stock price is far above or below the strike price the options is worth only its intrinsic value. Consider a stock which is currently selling at Rs 50. The call option to buy the stock at Rs 49 costs Rs 4. Here, the call premium is Rs 4, which is a sum of both the intrinsic value and time value. The intrinsic value of the option is Re 1 (50 – 49). The time value is Rs 3 ( 4 – 1).
Cash settled: When the investor is paid the differences between the strike price and the market price on expiry. Index options are always cash settled as physical settlement of the index itself is impractical.
Delivery based settlement: When a put buyer delivers the scrips on the day of expiry and the seller is paid the expiry price. In case of calls, the buyer of a call gets the delivery of the scrips and makes the payment. Delivery based settlement is expected to be introduced in India in the coming future.
LEAPS (Long term Equity Anticipation Securities): In India options generally expire within three months or less. LEAPS are a variation of standard option contracts in the sense that they are long dated with an expiration date up to three years into the future. These long term options provide the holder the right to purchase (in case of a call), or sell (in case of a put), a specified amount of the underlying stock at a predetermined price for a specified period of time, which can be up to three years in the future. LEAPS enable investors to trade for the long term without making an outright stock purchase.
Option Greeks: Tools to measure the sensitivity of the option price to certain factors, such as stock price, time to expiry volatility interest rate, and amount and timing of dividends. Sometimes options become complicated when used in combinations or two or more factors affect option price simultaneously which lead to complications in analysis. Analytical tools are available, which help in simplifying complicated option position. These analytical tools are collectively referred to as Greeks and individually as delta, theta, gamma, rho and vega. Greeks are used by professional traders for trading and managing the risk of large positions in options.