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 price, before a set date. Part of the option's price reflects what it would be worth if used immediately, which is the intrinsic value.
Everything above that is time value, sometimes called extrinsic value. Time value is what you pay for possibility.
An option that is not yet profitable can still be worth something if there is a decent chance the share price will move far enough before expiry. The more time remaining, and the more the share price tends to jump around (its volatility), the more that chance is worth.
This is why time value shrinks as the expiry date approaches, a process often called time decay. Each passing day removes a little of the chance that the price will move, and the decay speeds up in the final weeks.
An option holder who is right about the direction of the price can still lose money if the move arrives too slowly. Time value also depends on interest rates and on dividends the underlying share is expected to pay, though these matter less than time and volatility.
Options that are close to the strike price, called at the money, carry the most time value because their outcome is the most uncertain. Options that are deeply in the money or far out of the money carry less.
For a finance team, the idea matters most when options are used to hedge, or when employee share options are valued for the accounts. The cost of a hedge is mostly time value, so a longer hedge costs more.
Share option expenses are likewise estimated with models that include a value for the time remaining. Do not confuse this with the time value of money, which is the separate idea that a dollar today is worth more than a dollar in the future.
The two share a name and a theme of time, but the option version is about uncertainty in price, not about interest.
In practice
Real-world examples.
Example
A trader buys a call option on a technology share for $8.50, when its intrinsic value is $5.00. The trader recognises that $3.50 of the price is time value and decides to sell the option three weeks before expiry rather than hold it to the last day, when the time value would be gone.
Example
A corporate treasurer buys a protective put option to hedge the value of shares the company holds in another business. A twelve-month option costs far more than a three-month one because it has much more time value, so the treasurer rolls shorter options forward instead.
Example
A start-up values the share options it grants to employees. The finance lead uses a pricing model whose inputs include the time to expiry and volatility, and the resulting time value is a major part of the expense recorded in the accounts.
Formula
Calculation
Time value = option premium - intrinsic value
Intrinsic value of a call option = the greater of (share price - strike price) and zero
Suppose a call option with a strike price of $100 sells for $8.50 when the share trades at $105.
Intrinsic value = 105 - 100 = $5.00.
Time value = 8.50 - 5.00 = $3.50.
If the share price is unchanged at expiry, the option is worth only its $5.00 intrinsic value, so the $3.50 of time value has disappeared and the holder has lost $3.50 per share.Case study
Seen in the real world.
Ashgrove Energy is an illustrative, fictional company that sells electricity and holds a small portfolio of shares in a listed supplier. Its treasurer wanted to protect the portfolio, which was worth $2 million, from a price fall over the next year.
She priced a one-year put option and a series of three-month puts. The one-year option cost about $120,000, nearly all of it time value, while a three-month option cost about $35,000, which would total $140,000 if renewed four times.
The illustrative decision was to buy the one-year option, because the total cost was lower and it avoided the risk that the next quarter's options would be more expensive. She also recorded that most of the premium would decay to zero if the shares stayed flat, so the hedge was an insurance cost and not an investment.
Watch out
Common mistakes.
- Believing an option is worth nothing when it is out of the money, when it still carries time value that reflects the chance of a move.
- Buying options close to expiry and expecting them to behave like options with months to run, when time value falls fastest at the end.
- Confusing the time value of an option with the time value of money.
Questions
People also ask.
Why does time value fall to zero at expiry?
At expiry no time remains for the price to move, so the option is worth only what it would be if exercised, which is its intrinsic value.
What makes time value bigger?
A longer time to expiry, higher expected volatility and a strike price close to the current share price all increase it.
Can an option have time value but no intrinsic value?
Yes, an out-of-the-money option has no intrinsic value, so its entire price is time value.
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