Article of the Week from Online Trading Academy
by Russ Allen, Online Trading Academy Instructor
Last week I wrote about the idea of time decay in options. This is the gradual drop in an option’s value as time marches toward its expiration date.
But it is also possible that the amount of time value in an option can increase over time, at least up to a point. This has the same effect as turning the clock backward.
How can this happen? There are two things that can increase the amount of time value in an option.
First a quick review: an option’s value is made up of two components. The first is intrinsic value. This is just the difference between the option’s strike price and the current stock price. For calls, intrinsic value is equal to the current stock price minus the call’s strike price. If that calculation gives a negative number, the intrinsic value is zero. For puts, intrinsic value is calculated in the opposite direction – it is the put’s strike price minus the current stock price; or zero if that gives a negative number.
The second component of an option’s value is time value. It is an amount in addition to the option’s intrinsic value (if any), that accounts for the possibility that stock movement may increase the option’s intrinsic value before the option expires. At the end of the option’s life (on its expiration date), there is no longer any time for that stock price movement to take place, so the option’s time value at that time will be zero. At the moment of expiration every option’s value will be whatever its intrinsic value is at that moment.
So it makes sense that as time goes by, the opportunity for stock price movement diminishes and so time value should diminish as well.
Now, back to the two things that can counteract the passage of time and make an option’s time value actually increase from one day or week to the next.
The first of these is stock price movement. The full explanation is beyond our scope here, but the fact is that, all other things being equal, an option whose strike price is close to the current stock price will have more time value than an option whose strike price is farther away – in either direction. Since a particular option’s strike price is fixed, its time value changes as the stock price moves. The option’s time value increases as the stock price approaches it (either from above or from below). If the stock price moves away from the strike price, the option’s time value drops.
Below is a partial option chain that illustrates this effect:
Notice the far outside columns at each end of the chain labeled “Extrinsic.” Extrinsic value is another name for time value. Note that with GLD at $110.48, the 110 and 111 strike prices were just about equidistant from the stock price. The call options (left side) had extrinsic value amounts of $.77 for the 110 strike calls, and $.79 for the 111 strike. The calls whose strikes were a few dollars away from the $110.48 stock price had extrinsic value amounts that were much lower. The 107 calls, whose strike price was a little over $3 below the stock price had an extrinsic value amount of only $.14; and the $114 calls, whose strike was around $3 above the stock price, had only $.19 of extrinsic value. The other Extrinsic column, for puts, at the far right side of the chain shows a similar situation.
The amounts in the Extrinsic columns (and every column in the chain, for that matter) are not static. They change as the stock price moves. So as the stock’s price approaches an option’s strike price its time value expands, and as the stock price moves away it shrinks. Having the stock price come closer to any option’s strike price has the same effect as turning back the clock on that option.
The second thing that can inflate the amount of time/extrinsic value in an option, besides actual current stock price movement, is market expectation of future stock price movement. If the option-buying public comes to believe that the rate of movement of the stock’s price will increase (in either direction), then the amount of time value in every one of that stock’s options will increase. In other words, if people come to believe that a stock could move farther in the time until option expiration, they will pay more for the time value in the options.
So, as things change in the market an option’s time value can grow or shrink. Only one thing about an option’s time value is certain: no matter how much it may grow in the meantime, all of the option’s time value will be gone when the option expires.
The dynamics of time value are where the real excitement and profit opportunities are in the options market.
That’s all we have space for today. Educate yourself on this fascinating trading instrument.
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