When it comes to trading options one of the most basic and important aspects to understand is the concept of time value of an option. In technical parlance it is known as "Theta", which essentially represents the time decay of the value of an option. Before we get into the nuances of time value and time decay, let us quickly look back and refresh the concept of options.
So,what exactly are options all about?
As the name suggests, an option is a right without an obligation. This is in contrast to a futures contract which is both a right and an obligation. The buyer of the option has the right to buy or sell an underlying asset at an agreed price (strike price). If the price movement is in the favour of the buyer,then he will be profitable and if the price movement is against him then he will not exercise the option. Now that looks unfair to the seller of the option, doesn't it?
Not exactly! Since the buyer of the option has a right without an obligation, the seller of the option has an obligation without a right. The seller obviously will not do that free of cost. For this right without an obligation, the buyer of the option pays a certain fee to the seller of the option. This fee is called option premium and that is what get straded on the NSE when you buy and sell options. The option premium is basically the reward to the seller of the option for taking the obligation without the right and is paid by the buyer of the option.
Options can be call options or put options.A call options is a right to buy an asset while a put option is a right to sell an asset. If you expect the price of a stock to go up, you buy a call option.On the other hand, if you expect the price of a stock to go down, you will buy a put option. That surely sounds simple, but in reality it is not as simple as that.
Getting to the core of intrinsic value and time value of an option..
To understand the concept of time value,you need to first understand the 3 sub-categories of options as under..
1. In-The-Money (ITM) option is an option contract with a positive intrinsic value. In case of a call option on the Nifty it will be ITM if the market price is greater than the strike price.If the 9800 Nifty call option is trading in the market at Rs.70 and if the spot Nifty is at 9850 then the intrinsic of the Nifty call will be Rs.50(9850-9800). The time value of the option will be the residual value which is Rs.20 (70-50). So out of the option premium quoting in the market at Rs.70,intrinsic value accounts for Rs.50 and time value accounts for the balance Rs.20. In case of a put option, it will be ITM if the spot price of the Nifty is below the strike price of the put option.
2. At the money (ATM) option is an option contract with an intrinsic value of zero. In the case of a call option on the Nifty, it will be ATM if the market price is equal to the strike price.Since the intrinsic value is zero, the entire value of the option will be the time value.
3. Out-of-the-Money (OTM) options is an option contract where the market price is lower than the strike price in case of a call option and the market price is higher than the strike price in case of a put option. Mathematically, the intrinsic value as per our formula will be negative but since intrinsic value cannot be technical vale cannot be negative we will consider it as zero. The entire option premium, therefore,will be Time Value only.
As the above chart highlights, it is ATM options that offer the highest time value in the beginning of the month followed by ITM options and then by OTM options. Eventually, the time value in case of all the 3 options will eventually tend towards zero as expiry approaches. While the OTM option and the ATM option itself will have a zero value, in case of ITM options the option premium will still be positive due to the existence of intrinsic value.
Why is the concept of time value so important for options trading?
An option is a wasting asset, in the sense that the time value of the option tends towards zero as expiry approaches. This time decay is also referred to as Theta. Let us look at the time value of an OTM 10,000 Nifty Call for the month August 2017. Check out the chart below..
Since the 10,000 Nifty Call Option is OTM the entire premium value of the option is in the form of time value. We can see the time value diminishing from Rs.209.50 to Rs.2.30 over the span of one month.Had you sold this call options in the beginning of the month, this entire fall would have been your profit. On the other hand, had you bought these options,the entire premium would have been lost, if you had not triggered your stop loss earlier.
Two of the most important components of time value are time and volatility. Higher the time to expiry higher will be the time value both for call options and put options. Even if the option is still OTM, an increase in volatility can also bring about an increase in time value. While the buyer of the option bets on volatility pushing up time value higher, the seller of the option will hope for the time value of the option to work in his favour so that the option eventually expires worthless. This forms the basic premise of options trading!
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