The variety of options is becoming more and more abundant, and there are many choices for arbitrage and hedging. Some beginners have never understood the time value. Today, I will give you an in-depth explanation of what the intrinsic value and time value of options are. This article comes from: Option Sauce
01During the options trading process, everyone must have the following doubts:
❑ I read the market correctly, why the market is rising or falling. Neither putting nor calling makes money?
❑ What are the intrinsic value and time value of options?
❑ Once I am trapped, can I hold it until the expiration date?
In fact, the above points are all related to the value of time.
The option premiums we trade vary from high to low because the premium is composed of intrinsic value and time value.
In the picture we can see that the sum of time value and intrinsic value is the royalty.
02The concept of time value:
Think of it like a concert ticket worth 100 yuan. Due to the lack of tickets, scalpers sell it to 150 yuan. The extra 50 yuan is the time value, and the 100 yuan is the intrinsic value.
As the concert progresses, every minute and every second passes, and the ticket price will gradually decrease from 150 yuan to zero.
Let's look at it from another perspective. The option buyer actually wants to make money in the future and earn an expectation. Then you have to pay a cost, which includes intrinsic cost and time cost.
03What is the intrinsic value of an option?
The intrinsic value of an option, also known as the exercise value, refers to the income that the option holder can obtain when he immediately exercises the rights conferred by the option contract1.
The intrinsic value of an option is determined by the relationship between the exercise price of the option contract and the market price of the option underlying. Depending on the type of option, there are the following three situations:
The intrinsic value of an in-the-money call option is: the market price of the option underlying - the exercise price.
The intrinsic value of an in-the-money put option is: exercise price – market price of the option underlying.
The intrinsic value of the at-the-money call/put option is: 0.
04What is the time value of options?
The time value of an option, also known as the extrinsic value, refers to the value of the premium paid by the buyer of the option contract to purchase the option in excess of the intrinsic value of the option .
The premium of an option is composed of intrinsic value and time value. The intrinsic value of an option refers to the economic value generated by the immediate execution of the option, while the time value refers to the increase in expected income that the option contract may bring to the option holder over time and the fluctuation of positive and negative prices.
The “time value of an option” refers to the excess of the premium paid by the buyer of an option contract over the intrinsic value of the option.
The time value of the option is related to the remaining period of the stock conversion, the historical volatility of the stock price, and the current level of the stock price: the longer the remaining time for the stock conversion, the greater the price change, the higher the option time value; the greater the stock volatility, The higher the time value of the option; if the stock price is too high or too low, the lower the time value of the option.
Extended information
The time value of an option reflects both the time risk during the option trading period and the risk of market price changes. During the validity period of the option, the change of the time value of the option is a process from large to small, from existence to non-existence. Generally speaking, the time value of an option is directly proportional to the length of time the option is valid.
Intrinsic value: The actual value of an option, that is, its probability.
Time value: The cost to an option investor of financing the option.
Influencing factors
A measure of the volatility of the underlying security's price, calculated using the standard deviation of daily price changes.
Having said this, everyone must have some understanding of the time value of options!
Combined with what we mentioned earlier, why I don’t make money whether I’m selling, subscribing or putting when I’m right about the market. That’s because the value of time is constantly attenuating, and the market will slowly return to zero without big fluctuations.