Option’s TIME VALUE – Putting It Together – Part 2: Main Factors – Degree of Options Moneyness

Go back to Part 1: Understanding What Time Value is.

MAIN FACTORS THAT AFFECT OPTION'S TIME VALUE
As discussed in the previous post, Time Value of an option will be mainly affected by:
1) Degree of Options Moneyness
2) Implied Volatility (IV)
3) Time Remaining to Expiration

Let’s see how all these factors affecting Time Value can be explained by “the level of uncertainty as to whether or not an option can finish ITM”.

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option’s Strike Price with stock price (i.e. where the Option’s Strike Price is in relation to the current stock price).

The farther the Option’s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option’s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

Why is it so?
Because ATM or near ATM options would have a higher uncertainty level as to whether or not the options can finish ITM, as compared to OTM & ITM options do.
This uncertainty level can be explained by the how far an option’s strike price from the current stock price (i.e. degree of Options Moneyness).

For OTM options:
The farther the option’s Strike Price from current stock price is (i.e. deeper OTM options), the more likely / higher probability that the OTM option cannot become ITM before or at expiration.
Since it has “higher probability” that the deeper OTM options cannot finish ITM (or “lower probability” that the deeper OTM options can finish ITM), that means the options would have “lower level of uncertainty” as to whether or not it can finish ITM.
This explains why deeper OTM options, the lower the option’s time value.

For ITM options:
The farther the option’s Strike Price from current stock price is (i.e. deeper ITM options), the more likely / high probability that the ITM option can become ITM before or at expiration.
Since it has “higher probability” that the deeper ITM options can finish ITM (or “lower probability” that the deeper ITM options cannot finish ITM), that means the options would have “lower level of uncertainty” as to whether or not it can finish ITM.
This explains why deeper ITM options, the lower the option’s time value.

For ATM or near ATM options:
As the option’s Strike Price is equal to or near current stock price, it is still very uncertain if the option can or cannot become ITM before or at expiration.
In other words, ATM or near ATM options have “higher level of uncertainty” as to whether the options can or cannot finish ITM. As a result, their time value will be higher.



Continue to Part 3: Main Factors – Implied Volatility & Time to Expiration.

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks