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In [[finance]], the '''time value (TV)''' (''extrinsic'' or ''instrumental'' value) of an [[option (finance)|option]] is the premium a rational investor would pay over its ''current'' exercise value ([[intrinsic value (finance)|intrinsic value]]), based on the probability it will increase in value before expiry. For an [[Option style|American option]] this value is always greater than zero in a fair market, thus an option is ''always'' worth more than its current exercise value.<ref>Note, however, that there is also a cost component of holding an option (or any asset), based on the [[time value of money]].</ref> For a European option, the extrinsic value can be negative. As an option can be thought of as ‘price insurance’ (e.g., an airline insuring against unexpected soaring fuel costs caused by a hurricane), '''TV''' can be thought of as the ''risk premium'' the option seller charges the buyer — the higher the expected risk (volatility • time), the higher the premium. Conversely, '''TV''' can be thought of as the price an investor is willing to pay for potential upside.
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'''TV''' decays exponentially to zero at expiration, with a general rule that it will lose ⅓ of its value during the first half of its life and ⅔ in the second half. As an option moves closer to expiry, moving its price requires an increasingly larger move in the price of the underlying security.<ref>[http://www.investopedia.com/articles/optioninvestor/07/options_beat_market.asp  ''Understanding Option Pricing ''] Hans Wagner</ref>
 
==Intrinsic value==<!-- This section is linked from [[Option style]] -->
 
The '''intrinsic value (IV)''' of an option is the value of exercising it now. If the price of the underlying stock is above a call option strike price, the option has a positive monetary value, and is referred to as being [[in-the-money]]. If the underlying stock is priced cheaper than the call option's strike price, the call option is referred to as being [[out-of-the-money]]. If an option is out-of-the-money at expiration, its holder simply abandons the option and it expires worthless.  Hence, ''a purchased option can never have a negative value''.<ref>[http://www.investopedia.com/articles/optioninvestor/07/options_beat_market.asp  ''Understanding Option Pricing ''] Hans Wagner</ref>  This is because a rational investor would choose to buy the underlying stock at market rather than exercise an out-of-the-money call option to buy the same stock at a higher-than-market price.
 
For the same reasons, a put option is in-the-money if it allows the purchase of the underlying at a market price below the strike price of the put option.  A put option is out-of-the-money if the underlying's spot price is higher than the strike price.
 
As shown in the below equations and graph, the Intrinsic Value ('''IV''') of a call option is positive when the underlying asset's [[spot price]] ''S'' exceeds the option's [[strike price]] ''K''.
 
:Value of a [[call option]]: <math>\max[ (S-K) , 0 ]</math>, or <math>(S-K)^{+}</math>
:Value of a [[put option]]: <math>\max[ (K-S) , 0 ]</math>, or <math>(K-S)^{+}</math>
 
==Option value==
[[Image:Option value.gif|left|frame|Option Value]]
'''Option value''' (i.e.,. price) is estimated via a predictive [[formula]] such as [[Black-Scholes formula|Black-Scholes]] or using a [[numerical method]] such as the [[Binomial options model|Binomial model]]. This price incorporates the expected probability of the option finishing "[[in-the-money]]". For an out-of-the-money option, the further in the future the expiration date - i.e. the longer the time to exercise - the higher the chance of this occurring, and thus the higher the option price; for an in-the-money option the chance of being in the money ''decreases''; however the fact that the option cannot have negative value also works in the owner's favor. The sensitivity of the option value to the amount of time to expiry is known as the option's [[Greeks (finance)#Theta_.CE.98|theta]]. The option value will never be lower than its '''IV'''.
 
As seen on the graph, the full call option value ('''IV + TV'''), at a given time '''''t''''', is the red line.<ref>Note that the X axis is ''not'' time — the graph represents the relationship between price and value ''at a particular time''. With more time left to expiration, the red curve would be higher; the closer to expiration, the more it would approach the blue intrinsic value line.</ref>
 
==Time value==
'''Time value''' is, as above, the difference between option value and intrinsic value, i.e.
 
:<code>Time Value = Option Value - Intrinsic Value.</code>
 
More specifically, '''TV''' reflects the probability that the option will gain in '''IV''' — become (more) profitable to exercise before it expires.<ref>[http://www.oxfordfutures.com/futures-education/option-premium-valuation.htm ''Option premium valuation '']  22 August 2007</ref> An important factor is the option's [[Volatility (finance)|volatility]]. Volatile prices of the underlying instrument can stimulate option demand, enhancing the value. Numerically, this value depends on the time until the [[expiration date]] and the [[Volatility (finance)|volatility]] of the underlying instrument's price. '''TV''' cannot be negative (because the option value is never lower than '''IV'''), and converges to zero at expiration. Prior to expiration, the change in '''TV''' with time is non-linear, being a function of the option price.<ref>[http://demonstrations.wolfram.com/OptionsTimeValue/ Options: Time Value], wolfram.com</ref>
 
==See also==
* [[Intrinsic value (finance)]]
* [[Naked call]]
* [[Time value of money]]
 
==References==
{{reflist}}
 
==External links ==
*[http://biz.yahoo.com/opt/basics5.html Basic Options Concepts: Intrinsic Value and Time Value], biz.yahoo.com
 
{{Derivatives market}}
 
{{DEFAULTSORT:Option Time Value}}
[[Category:Options (finance)]]
[[Category:Finance]]

Latest revision as of 12:38, 5 May 2014

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