Option’s TIME VALUE – Putting It Together – Part 3: Main Factors – Implied Volatility & Time to Expiration

Go back to Part 2: Main Factors – 1) Degree of Options Moneyness

2) Implied Volatility (IV)
The higher the IV, the higher the option’s time value.

Why is it so?
Because higher IV reflects a greater expected fluctuation (in either direction) of the underlying stock price (e.g. due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically).
Therefore, when IV is higher, the options would be more uncertain as to whether or not the options can finish ITM. This explains the higher time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option’s time value.
Hence, all other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Why is it so?
Because the longer the time remaining to expiration, the underlying stock price would have more time to fluctuate, resulting in more uncertainty as to whether or not the options can finish ITM, and therefore the higher the time value.

As the option is approaching expiration, assuming all other things constant, the level of uncertainty will decrease, because the underlying stock price will have lesser time to move. Hence, the time value will decrease as the time to expiration gets shorter.

In general, for both Calls & Puts, as expiration is nearing, the Time Value component of an option price decreases or “erodes”. This is often called “Time Decay”.

Continue to Part 4: Behavior of Time Value

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