Option’s TIME VALUE – Putting It Together – Part 1: Understanding What It Is

As mentioned in “Option Price Components”, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price – Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price – Current Stock Price.

As can be seen in the above formula, it is only ITM options that have Intrinsic Value component, whose value is simply the difference between option’s strike price and current stock price.
Whereas for ATM & OTM options, Time Value is the only component of the options’ price / premium.

What Is Option’s Time Value?

As mentioned in the previous post - More Understanding about Options Time Value:

Time value can be viewed as “the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)”.
The more uncertain, the higher the time value will be.

In other words, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.
When it is more certain that an option can or cannot finish ITM, the time value will be lower.
In other words, when an option has “higher or lower probability” that it can or cannot become ITM before or at expiration, that means the “level of uncertainty” will be lower.
So, it is the level of uncertainty that matters, not whether it has higher or lower probability to finish ITM or not finish ITM.

In the next post, we’ll discuss further with more elaboration and examples about how this “level of uncertainty” could explain option’s time value.

Continue to Part 2: Main Factors that Affect Option’s Time Value.

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* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
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* Option Greeks