Elements of the price of an option
When someone who is options trading buys or sells an option, the price of it is determined by a few factors.
These are:
- The intrinsic value of the option.
- Plus: the extrinsic value, which depends on:
- The time to expiration.
- The risk-free interest rate.
- Volatility.
- Dividends.
Only ITM options have intrinsic value. Let us assume the share price of company ABC is currently 100USD. A call option with a strike price of $80 will have an intrinsic value of $20.
If that option sells for $24, therefore, the intrinsic value is $20 and the rest ($4) is extrinsic value, of which time value, determined by the time to expiration, is an important component.
Time value
If one looks at a typical options chain, it is immediately clear that the more time there is until expiration, the more expensive the options become. The newer 1-week options are, everything else being equal, much cheaper than 1-month options, which are in turn much cheaper than 3-month options.
This is simply because with more time to expiration the price of the underlying asset has more scope to move up or down. The options writer needs to be compensated for this risk, otherwise there is little sense in writing (selling) an option.
Time decay
When a trader therefore buys a call or put option, a certain percentage of the purchase price is for time value, i.e. to compensate the options writer for the risk he is taking during the time left to expiration.
What is vital to understand here is that the closer to expiration the options come, the less time value they will have. Even if the price of the underlying asset does not move a single cent, your call or put option will lose its time value component as the expiration date approaches and eventually it will expire worthless. This is referred to as the time decay of options.
For options buyers time decay is their biggest enemy. The price of the underlying has to move beyond the strike price of their options by the expiration day, or they will become worthless. For options sellers this often becomes their best friend: all they need is for the underlying price to remain on the ‘right’ side of the strike price long enough and they will keep the full options premium.
What is interesting to note here is that options tend to suffer more time decay during the last 30 days of their lifetime than during earlier months. This is why many options sellers only sell options with an expiration date that is no more than 30 days away. Options buyers, on the other hand, need as much time as possible to give their options an opportunity to reach their strike price.
Summary
It is important to understand how time to expiration influences the value of options. An option buyer is literally ‘buying time’ when he or she purchases longer term options, while an options seller will get bigger premiums for a longer term option than for a short term one, but this means additional risk because there is more time left for things to go wrong.
This article presented by Marcus Holland, the editor of FinancialTrading.com – a new but fast growing education resource on all aspects of financial trading
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