BACK TO BASICS: Understanding Intrinsic and Time Value
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January 9, 2006
When evaluating option premiums it is very important to understand that it primarily consists of two parts: intrinsic value and time value. Essentially, time value represents the advantage or disadvantage of time remaining in the option lifetime. Intrinsic value, also referred to as the in-the-money value, only exists when the underlying asset’s price is higher than the underlying’s strike price of the call or lower than the strike price of the put.
LEAPS (Long Term Equity Anticipation Securities) options in the equity markets make premium value predictable because of the underlying stock’s ever-changing market value. The more volatile the stock’s trading pattern, the more likely the LEAPS option’s time value will be higher as a result. The Intrinsic Value is derived at using a fairly straightforward calculation. The strike price is subtracted from the stock’s current market value as long as market value is higher than the striking price for a call or lower than the striking price for a put. When a call’s strike price is greater than the stock’s market value or when a put’s strike price is less than the stock’s market value, there is no Intrinsic Value.
Time Value is the difference between total option premium and intrinsic value. For example, when the LEAPS contract is out-of-the-money, the entire premium is time value. For buyers, time value is a continual problem because as time passes, it declines. Thus even when a stock is moving upward, it may only offset what the buyer paid for the option.
For option sellers tine value is a huge advantage because it decays or evaporates over time allowing sellers to profit even if the underlying stock moves only a few points or not at all. Time value changes in more of a predictable pattern, especially when dealing with LEAPS. Typically the LEAPS can have a lifetime of up to three years, so time value will not change significantly in the early months. However, as expiration date approaches the decline in time value accelerates and eventually reaches zero at the point of expiration.
These facts allow the options seller to time their trades so that they are exposed in a short position for the least amount of time possible, but to maximize the advantage of declining time value. Option buyers on the other hand need enough increase in intrinsic value to not only gather value, but also to offset the declining time value.
The key point for traders to keep in mind when working with LEAPS or options over 90 days is that the early months are advantageous to the buyer, because time value declines slowly, but the later months are very disadvantageous, because time value declines more rapidly. No matter the rationale an options trader has for trading LEAPS or longer-term options, this inescapable fact will dictate their timing and strategies, which will ultimately determine whether a profit is realized or a loss is incurred.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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Listen to Jeff at www.ProfitStrategiesRadio.com
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