Options Time value – Key Points About Selling Options Part 5
Options Time Value – Key Points About Selling Options (Part 5)
Now, once we reach expiration time all ‘at the money’ and ‘out of the money’ options are going to expire worthless. They’ll have no value, so once expiration is reached time value is gone. So, let’s look at that with an example as well. Time value also known as extrinsic value is the amount of the premium above its intrinsic value. Intrinsic is very simple to calculate is either zero or it’s the ‘in the money’ amount. Beyond that, whatever is left over is time value and I’ll separate these two in another way. The intrinsic value is sensitive to stock price movements. The time value is sensitive to a number of other factors including the passage of time, the movement of volatility, changes in dividend payments.
There’s a number of different factors in time value. It’s a rather complex calculation to go through but, knowing how much is there and how much it changes from one day to the next is what you’re trying to understand. So, with shares trading at $77.50 an investor sells the $75 strike call option at $3.50. First question is what’s the moneyness of this option? The owner of this option has the right to buy shares at $75. That’s better than $77.50. So, it’s ‘in the money’ simple arithmetic, it’s ‘in the money’ by two and a half dollars. So, there is intrinsic value in the amount of two-and-a-half. The option traded for three and a half dollars, so that means the extrinsic value or time value portion of this premium is $1. The seller of the call option is trying to capture $3.50 only if they want short Deltas and they are bearish.
That is the motivation of the call seller. If they owned shares of stock say from a lower case then the seller of this call option is only trying to capture one dollar. That’s because they own shares and by selling this option, they are willing to sell their stock two and a half dollars below the current value. The only thing they’re trying to add to their bottom line or portfolio return is that one dollar of extrinsic value and you can track that. I’m going to walk through that as we get to the simple strategies on the next slide. But, a number of different factors go into what time value is made of and it’s also important to understand that the time value can disappear and then reappear.
Once it’s gone, it doesn’t necessarily mean it stays that way. The simplest example I can give you is if an ‘at the money’ option today, which has no intrinsic value at all is trading for two dollars. And for whatever reason, let’s say it’s a $70 strike call option, I’m going to go through an extreme absurd example, which is something I do very frequently when I teach. If the stock all of a sudden news broke that it was going bankrupt and the stock dropped all the way down to $10, this is the $70 strike, there’d be no value left in that option. It’s deep, deep ‘out of the money’ all the time value disappeared. And then an hour later, news broke that that was an inaccurate fake news story and the stock went right back to $70. All of a sudden, it’s at the money again with the same length of time to expiration that time value came back as the option moved from ‘at the money’ to ‘in the money’ back to ‘at the money’. Same thing can happen with the effect of volatility. You can have a decrease in volatility followed by an uptick in volatility and that changes time value in both directions. Understanding all of that will help you keep track of the price of an option over time and understand why it moves the way it does. It’s rather interesting to absorb the fact that time value can disappear and then come back depending on market circumstances.