Understanding time value when buying options - Motilal Oswal

Understanding time value when buying options




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In the sphere of investment, investors have a number of choices in the ways to invest, as well as a range of investment instruments to invest in. While investing, any investor seeks to minimise risks, while making sure of attaining substantial rewards. A way to invest in some securities is to get into an options and futures contract. This is now a common way to trade and invest in underlying assets like stocks, commodities, etc. Both futures and options contracts are largely based on the duration of a contract which investors enter into to buy or sell underlying assets (as mentioned in the contract). Therefore, as time plays a key role in any futures and options contracts, it is important to be aware of its value with any contract. Here, we delve into the value of time/duration mentioned in an options contract and view how this plays a role in the undertaking of the contract. 

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?

While getting into an options contract, investors must know how pricing is determined in the contract (essentially via the underlying asset) and the role that the decay of time plays in the pricing of an options contract. 

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 option 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! It may seem like this at first glance, but you should understand the concept of how selling works with options to fully understand its function. 

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 gets traded 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 option 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 subcategories 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 an 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 value 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. The decay of time naturally tends towards zero as there is less and less time to the expiry date of the options contract. 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 these 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.

Why Time Value is Vital in the Trading of Options

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!

Main Takeaways

When trying to establish positions, option sellers may gather a time-value premium which is paid by the buyers of options. Instead of losing out due to the decay of time, the seller of options can get an advantage from the passage of time, plus the decay of time value turns into money even though the underlying asset remains stationary. While grasping the full importance of time value in options trading, some main points should be kept in mind always: 

  • The contracts of options grant the holders of options contracts rights to purchase or to sell any underlying asset/security before or at a date of expiry fixed by the contract. Therefore, the contract is typically executed at some point in the future. 
  • In terms of price, that determined by an options contract, called as a premium, is primarily related to the probability of the option expiring “in-the-money”, or in other words, with a value that is towards the positive side. 
  • As the time of expiry of an options contract slowly approaches, the chance of a big enough move in the price of the underlying asset to get the contract “in-the-money” decreases, and so does the premium. 
  • What this is called, effectively, is time decay. You should note that all else remains equal and an options price declines over a period of time. 

Aspects to Consider

In futures and options contracts (although we have spoken about options here), there are other dimensions that are linked to pricing, like delta, implied volatility, and gamma. All these must be considered if you are going into an options contract. However, the decay in time value is crucial to grasp the way in which any options are priced.

 

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