Assuming all other things remain constant (i.e. no changes in the underlying stock price and volatility), the time-value component of an option is affected by 2 variables (both for Call & Put Options):
* Time remaining until expiration.
The longer the time to expiration, the more time value the option will have.
* The closeness of the option Strike Price to the money.
At-The-Money (ATM) options have the maximum level of time value, and the time value decreases as it moves to deeper In-The-Money Options (ITM) and deeper Out-Of-The-Money (OTM) options (like inverted-U curve).
Time value is at its highest level when an option is ATM because the potential for Intrinsic Value to begin to increase is the greatest at this point.
Note:
ATM options have the highest level of time value. Time value decreases as it moves to deeper ITM or OTM options (like inverted-U curve).
This can be understood better if we see the time value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.
The more uncertain, the higher the time value will be.
An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.
In addition, we know that for both Calls & Puts, the time value component of an option price decreases as expiration is nearing, and the decrease rate is accelerating as it is getting closer to expiration, particularly for At-The-Money (ATM) options. This means that the amount of time value disappearing from the option price per day gets bigger with each passing day.
Please note here that Time Value decrease at an accelerating rate as expiration nears is true only for ATM option. This is because for ATM option, Theta increases as an option get closer to expiration (Please refer back to the previous post here).
For ATM option, time value decreases sharply particularly the last 30 days before expiration.
Nevertheless, for both ITM & OTM options, Theta decreases as an option is approaching expiration. Hence, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears.
Sigma Options had a good article about this in “What You Didn’t Know About Time Decay”.
Related Articles:
* In-The-Money, At-The-Money, and Out-Of-The-Money Options
* Option Price Components
* Options Pricing: How Is Option Priced?
* Option Greeks
0 comments:
Post a Comment