What does time value of options depend on?
While an option’s intrinsic value is easy to calculate just by looking at its strike price and the underlying’s market price, time value doesn’t have any simple and quick formula like this. There are more factors influencing time value of an option. Among the most important are time to expiration, interest rates, and moneyness – or whether an option is in the money, at the money, or out of the money, and how far. This article deals with the last factor mentioned.
Maximum risk for an option’s owner
What is your total risk (what can you lose in the worst case) when you own an option? Same as with most other assets, the maximum possible loss for an option’s owner is the market price of the option. The worst case scenario is that you will be holding the option until expiration and the option will expire worthless.
Market price of every option is the sum of its intrinsic value and time value. When you add up the two, you get your maximum risk.
Deep in the money call option
When an option is deep in the money, you risk a lot in intrinsic value. For example, you have an option with a strike price of 20 on a stock which currently trades at 50. The intrinsic value of this option is 30 dollars per share and you can theoretically lose this all if the stock falls sharply under 20. So your total risk as the owner of this option is its market price, equal to intrinsic value plus time value.
At the money call option
Now compare this with another option on the same stock, but with the strike price of 50. Because the underlying stock trades also at 50, the option is at the money. The intrinsic value of this option is zero. Your total risk as the owner of this option is its market price which in this case equals only its time value.
Compare total risk of the options
Imagine that the time value of both option was the same, let’s say 2 dollars. Now what would your total risk be in each case?
In the deep in the money option example, your total risk (the option’s market price) would be 30 + 2 = 32 dollars. In the at the money option example your total risk would be just the 2 dollars.
Profit potential of call options
Is the profit potential of the two options different? No, it isn’t. Both are call options on the same stock and both would make you a profit if the stock trades above 52 at expiration (assuming you would wait till expiration and then exercise the options).
Your total profit from holding the option in both cases is 1 dollar for every dollar by which the price of the underlying stock will exceed 52 (market price of the underlying stock at the moment of buying the option plus time value of the option at the moment of buying the option).
People prefer less risk to more risk with same profit potential
So what would you prefer to do? Risk 32 dollars or risk 2 dollars if the profit potential is the same in both cases? Of course every rational person would prefer to risk less.
This is why in reality the time value of the at the money option would be higher than the time value of the deep in the money option. People are willing to pay an extra price in the time value for reducing their risk.
Long stock is long call with zero strike price
Let’s add the third case to our two examples from above. Consider buying the stock itself instead of buying the options. A stock has no time value, as there is no optionality in it. In fact a stock is like a call option with a strike price of zero (and the underlying asset is the stock itself). The whole market price of this “option” is made up from intrinsic value (market price of the underlying less strike price) and its time value is zero. If you own a stock, your maximum risk is its market price. You can look at long stock as an extremely deep in the money call option with zero strike and zero time value.
Conclusion: time is worth the most at the money
The reason is that the ratio of expected profit to maximum risk is the best here and therefore the benefit from having the choice (to exercise or not) is the greatest here.
For in the money call options, the closer an option is to a long stock position – this means the lower its strike price is – the smaller its time value will be. The time value will increase as the option gets closer to the at the money area.