Options Trading: Time Value

Submitted by Stock Market News on 3 June, 2011 - 18:05

Time Value of Options

Time value is one of the most important components in options trading. Options have an expiry date, so the value of an option depends on the time it has left. It's a speculative form of trading with a wasting asset, but with enough research to know what determines the value of an option, you will get an insight in how you can make the most out of your options trading. We will look into the factors that affect an option's time value, which is an integral part of options trading.

Expiry Date

The longer your expiry date is the higher the value of your options becomes. Your expiry month must be long so that the underlying shares will in your favour as far as possible. As the time passes, the value of your option decreases a process which is referred to as time decay. When your option expires, your option will no longer have a time value but an intrinsic value.

Time decay is not exactly constant. In its early stages, the decay is gradual and then accelerates as your option expires. An option usually one third of the time value is lost during the first half, and then two thirds in the remaining half of its life. Time decay works against the trader, especially when the market did not move according to what you expect.

When you choose the expiry month, it must be balance between the cost of the option and the time you need for your strategy to work. A longer expiry may provide more room, but it can also be expensive. You will pay more for longer term expiry date than a short one.

Volatility

It's how far and how fast the share price will move in the market. Some stocks are more volatile than others – a stock's price may move over a wide range in a short period of time. They also vary over time. A stock mat move steadily within a particular range for a period of time before may any significant movements. It is expressed in an annualised percentage. With current price, traders can use volatility to identify the probability of a stock's trading range next year.

It works in favour of the option holder. The more volatile the underlying stock is the chance for a significant move in share price to take place, which in turn prepares you to pay for the option.

On the other hand it works against the option writer. You are exposed to a higher risk of a move in share price that can damage you position, and you will have a high premium to compensate for that risk.

Dividends

If the underlying stock goes ex-dividend within the options' expiry month, the price will be affected. The stock price usually falls by the amount of its dividend. It will then be lower at the expiry date than it would have been if the stock did not go ex-dividend. If the company announces a higher or smaller dividend than you expected the option's price will get affected as the dividend priced into that option has already changed.

Call and put premiums are affected in a different way.

If you are a call buyer, the stock price should be as high as possible at the expiry date. Since the stock's price fall when it goes ex-dividend you will not be prepared enough to pay for a high premium.

A put buyer on the other hand, will not be as affected. Put options become more valuable as the stock price gets lower so they are prepared if the ex-dividend date falls within the expiry month.

Interest rates

When you buy a call, the premium you will pay is just a small percentage of the underlying shares. You don't have to pay for the shares unless you exercise your option, which you can delay until the expiry date. Until you exercise your option it is assumed that you're funding the shareholding and earn from the interest. The higher the interest rates are the more the funding benefit will be, and the higher your premium will become.

These components have a bearing in the value your option over time, so you have to be careful in choosing your expiry date. Make sure that it will provide enough time to give you the opportunities you need, but also weigh your options between long term and short term options trading.