Note: Intrinsic value arises when an option gets in the money. This should make the above concepts more tangible. Through this presentation, we are making the assumption for simplification that implied volatility levels remain unchanged and the underlying asset is stationary.
This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer. Assume the date is February 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates February, March, and Aprilthe phenomenon of time-value decay becomes evident.
Major Factors Influencing Options Premium
We can witness how the passage of option time premium changes the value of the options. As the figure below shows, the highest premium is at the day interval remember prices are from February 8declining from there as we move to the options that are closer to expiration 33 days and five days. Again, we are simply taking different prices at one point in time for an at-the-option strikeand comparing them.
The fewer days remaining translates into less time value. One important dynamic of time-value decay is that the rate is not constant.
As expiration nears, the rate of time-value decay theta increases not shown here. This means that the amount of time premium disappearing from the option's price per day is greater with each passing day. In the last month of the life of an option, theta increases sharply, and the days required for a 1-point decline in premium falls rapidly.
At five days remaining until expiration, the option is losing 1 point in just less than half a day 0. This means that the premium will decline by approximately 2.
Of course, the rate increases even more in the final day of trading, which we do not show here. Article Sources Investopedia requires writers to use primary option time premium to support their work.
- Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
- Also known simply as option price.
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Time premium is sometimes called "extrinsic value"; it means the same thing. Let's look at how we calculate these values. The option is OTM out of the money because the strike 20 is above the current stock price There is no intrinsic value in this option.
Commodity Futures Trading Commission. Accessed Apr. University of Northern Iowa.
Search the Archives Time Premium A time premium is the amount by which the price of option time premium stock option exceeds its intrinsic value. An out of the money option is all time premium. A stock option reaches its highest level of time premium when the stock and the strike price are equal at the money. This is because the option has no intrinsic value yet it is about to gain intrinsic value. As the option moves further and further in the moneythe intrinsic value increases and the time premium decreases as a percentage of the total price of the stock option.
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