What it means
An option gives its holder the right, but not the obligation, to buy or sell an asset at a fixed price called the strike. Its market price splits neatly into two parts: intrinsic value, which is the immediate gain from exercising, and time value, which is everything the buyer pays for the possibility of things improving.
Time value exists because uncertainty has worth to an option holder. Losses are capped at the premium paid, while gains are open ended, so more time and more volatility both make the option more valuable even when nothing has happened yet.
The figure matters commercially because it is the true cost of the insurance an option provides. A company hedging fuel prices or currency exposure is buying time value, and comparing that cost against the risk being covered is the whole decision.
Time value does not fall in a straight line. It decays slowly at first and then accelerates in the final weeks, an effect traders call theta, which is why holding an option to the last day is usually the most expensive way to be right.
Two forces set the size of time value: how long remains until expiry and how much the underlying price is expected to move, a quality traders call implied volatility. A calm market with three weeks left produces very little time value, while a nervous market with a year to run produces a great deal.
An option that is far out of the money, meaning exercising it would produce nothing, has zero intrinsic value and is therefore priced entirely on time value. That is why such options can lose almost all their worth even when the underlying price barely moves.
In practice
Real-world examples.
Example
A treasury team buys a three month currency option to protect a $4,000,000 supplier payment. The option is at the money, so the entire premium is time value, and the finance director presents it to the board as the price of certainty rather than as an investment.
Example
An employee holds share options struck at $12 while the shares trade at $11. There is no intrinsic value, yet the options still have a positive value in the accounts because five years remain before they lapse.
Example
A commodities trader sells short dated options on grain futures and buys longer dated ones. The position is built entirely around the fact that time value decays faster in the near contract than in the far one, so the premium collected on the near leg erodes more quickly than the premium paid on the far leg.
Think of it
“Time value is the extra cost for time remaining-what you pay for possibility of future gains.
Formula
Calculation
Time value = option premium - intrinsic value, where intrinsic value for a call option is the share price minus the strike price, floored at zero.
Suppose a share trades at $56.00 and a call option with a $50.00 strike, expiring in three months, is quoted at a premium of $8.20. The intrinsic value is $56.00 - $50.00 = $6.00 per share.
The time value is therefore $8.20 - $6.00 = $2.20 per share. On a standard contract of 100 shares the buyer is paying $600 for immediate value and $220 for the remaining three months of possibility, and that $220 falls to zero by expiry if the share price stands still.Case study
Seen in the real world.
The following is an illustrative and fictional scenario. Coldspring Beverages, an invented drinks bottler, hedged its aluminium exposure by buying call options every quarter. The purchasing manager always bought contracts with one month left because they were the cheapest on the screen.
A review by the fictional company's new treasurer showed why they were cheap. The one month options carried very little time value, so they only paid off when the aluminium price moved sharply within days, and in eleven of the previous twelve quarters they had expired worthless.
Switching to six month options raised the annual premium bill from $180,000 to $420,000 but produced payouts in three of the next four quarters. Coldspring's illustrative lesson was that the cheapest premium is not the cheapest hedge, because the missing time value was exactly the protection the business needed.
Watch out
Common mistakes.
- Assuming an option is a bargain because the premium is small, when a low premium usually means very little time value and a very low chance of paying out.
- Expecting time value to fall evenly across the life of the option instead of accelerating downwards in the final weeks.
- Confusing time value with the time value of money, which is a separate idea about discounting future cash flows.
Questions
People also ask.
Can time value ever be negative?
No, it cannot fall below zero, because an option will not trade for less than the profit available from exercising it.
What makes time value larger?
Longer periods to expiry, higher expected volatility in the underlying asset and a strike price close to the current market price all increase it.
Does time value matter if I intend to exercise immediately?
Yes, because you paid for it in the premium, and exercising early hands that portion of the price back to the seller.
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