Time value
Also written Time value of an option · Extrinsic value
The part of an option premium that is not intrinsic value — what the buyer pays for the possibility that the underlying moves further in his favour before expiry. It falls to zero on expiry day.
In plain language
An option premium has exactly two parts and no others.
Intrinsic value is what the option is worth if you exercised it this second. Time value is everything else — the price of the remaining chance. It is what is left when you subtract the intrinsic value from the premium, and for an at-the-money or out-of-the-money option it is the whole premium, because the intrinsic value is zero.
Time value is the interesting half, because it is the half that is doomed. Intrinsic value is arithmetic: as long as the option is in the money at expiry, it is there. Time value is a bet on what has not happened yet, and on expiry day there is no "yet" left. Time value is always zero at expiry. That is why options are called wasting assets.
How it works
Time value is driven by two of the five option-pricing parameters:
- Time to expiry. Longer means more chance of a favourable move, so more time value. A three-month option on the same strike trades above a one-month option.
- Volatility of the underlying. More movement means more chance of finishing deep in the money, so more time value — and this works identically for calls and puts. When volatility spikes on an unexpected event, calls and puts both get dearer.
It peaks at the money, for the reason given in at-the-money: that is where a small move decides everything.
And it decays. The workbook draws the conclusion sharply: of the two components of an option price, one of them is inherently biased towards reducing in value, so if nothing else changes at all, the option price will fall by expiry. That is the structural advantage the writer has over the buyer, and it is measured by theta.
The formula
Option premium = Intrinsic value + Time value
Time value = Premium − Intrinsic value
Intrinsic value of a call = max(S − X, 0)
Intrinsic value of a put = max(X − S, 0)
At expiry, time value = 0, so the premium collapses to the intrinsic value and nothing else.
A worked example
The Nifty spot is 18,315.10. Both options are struck at 18,400 and expire on the same day. The contract size is 50.
The put, premium Rs 177.60. The strike is above the spot, so the put is in the money:
Intrinsic value = 18,400 − 18,315.10 = Rs 84.90
Time value = 177.60 − 84.90 = Rs 92.70
The call, premium Rs 124.50. The strike is above the spot, so the call is out of the money:
Intrinsic value = 0
Time value = Rs 124.50, the whole premium
In rupees per contract:
| Put | Call | |
|---|---|---|
| Premium paid | Rs 8,880 | Rs 6,225 |
| Intrinsic value | Rs 4,245 | Rs 0 |
| Time value at risk | Rs 4,635 | Rs 6,225 |
Now let the index finish exactly where it started, at 18,315.10, on expiry day.
The put holder receives 84.90 × 50 = Rs 4,245 against Rs 8,880 paid — a loss of Rs 4,635, which is precisely the time value. The call holder receives nothing and loses the full Rs 6,225, which is also precisely its time value.
Nothing happened in the market, and the two buyers together lost Rs 10,860. That Rs 10,860 is exactly what the two writers kept. Time value is not an abstraction; it is the amount that changes hands when the market does nothing at all.
Why NISM asks about it
Chapter 16.4 (Intrinsic value and time value of an option) is built entirely on the 18,400-strike example above, and Chapter 16.7 explains which parameters move the time value. Expect a two-step computation — find the intrinsic value, subtract to get the time value — and a conceptual question on which moneyness category has time value only. All three do at some level; only ATM and OTM have nothing but time value.
Common exam traps
- Time value is a residual, not a rate. It is premium minus intrinsic value, computed second. Candidates who try to compute it directly get lost.
- ITM options also have time value. The workbook's own put shows Rs 92.70 of it. Only at expiry is it zero, for every option.
- Intrinsic value cannot be negative, so the time value of an OTM option is the entire premium, never more.
- Volatility lifts the time value of calls and puts alike. It is the one parameter that moves both premiums the same way.
- Time value does not decay in a straight line. It falls fastest near expiry, which is why a week-old position and a day-old position bleed at very different rates.
- Longer-dated means more time value, not a better trade. You are paying for a bigger wasting asset.
Where this is taught
- Series VIII · Chapter 4: Introduction to Optionsintroduced here
- Series V-D · Chapter 16: Introduction to Optionsintroduced here
- Series XVI · Chapter 4: Commodity Optionsintroduced here
- Series IV · Chapter 4: Exchange Traded Interest Rate Optionsintroduced here
- Series I · Chapter 4: Exchange Traded Currency Optionsintroduced here
- Series V-D · Chapter 21: Exchange Traded Interest Rate Options
Related terms
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- At-the-moneyAn option whose strike price is closest to the spot price, so exercising it immediately would produce neither a gain nor a loss — the strike where the whole premium is time value and uncertainty peaks.
- Implied volatilityThe volatility figure that, put into an option pricing model, reproduces the option's actual market price — the market's consensus forecast of how much the underlying will move.
- ThetaThe option Greek that measures time decay — the change in an option's premium for a one-day decrease in time to expiry. It is negative for a long option, call or put alike.
- Time decayThe steady loss of an option's time value as expiry approaches — the reason options are called wasting assets and the reason the workbook says option sellers hold a structural advantage.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
- Wasting assetAn option, whose time value shrinks towards zero every day it is held and is worth nothing at expiry — so an option buyer loses money simply from the passage of time.
- Out-of-the-moneyAn option that would produce a negative cash flow if exercised immediately — a call with the spot below the strike, or a put with the spot above it. Its intrinsic value is zero and its premium is all time value.
- Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
- Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
- Break-even pointThe level of the underlying at which a position makes neither profit nor loss — for a bought call, strike plus premium; for a bought put, strike minus premium.
- VegaThe option Greek that measures sensitivity to volatility — how much an option premium changes for a one per cent change in the implied volatility of the underlying. It is positive for a long call and a long put alike.
- Historical volatilityVolatility measured backwards — the standard deviation of the underlying's past percentage price changes, as against implied volatility, which is worked out forwards from the option price.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- Horizontal spreadTwo options of the same type and the same strike but different expiries — a position whose entire value is the difference between the two legs' time values, not a view on direction.
- Diagonal spreadTwo options of the same type on the same underlying with both a different strike and a different expiry — the most complicated of the three spread families, and the only one that varies on both axes.