Understanding Time Value in Options: Definition, Role, and Calculation

What Is Time Value?

Time value refers to the portion of an option's premium that's attributable to the amount of time remaining until the expiration of the option contract. The premium of any option consists of two components: its intrinsic value and its extrinsic value.

Time value, along with implied volatility (IV), makes up an option's extrinsic value. It relates to derivatives markets. It shouldn't be confused with the time value of money (TVM), which describes the discounting of money's purchasing power over time.

Understanding the Fundamentals of Time Value

The cost of an option is called the premium. An option buyer pays this premium to an option seller in exchange for the right granted by the option: the choice to exercise the option to buy or sell an asset or to allow it to expire worthless.

Intrinsic value is the difference between the underlying asset's price and the option's strike price. The intrinsic value for a call option is equal to the underlying price minus the strike price. The intrinsic value for a put option, which is the right to sell an asset, is equal to the strike price minus the underlying price.

An option's total premium is based on its intrinsic plus extrinsic value. A key part of extrinsic value is known as "time value." A contract normally loses value as it approaches its expiration date because there's less time for the underlying security to move favorably. An option with one month to expiration that's out of the money (OTM) will have more extrinsic value than that of an OTM option with one week left to expiration.

Implied volatility (IV) also impacts extrinsic value and time value. IV measures the amount an underlying asset may move over a specified period. The extrinsic value will also increase if the IV increases. The extrinsic value would rise as investors figure that dramatic moves boost the possibility of the asset moving their way if an investor purchases a call option with an annualized IV of 20% and the IV jumps to 30% the following day.

How to Calculate Time Value in Options

Time value might be expressed like this as an equation:

Option Premium - Intrinsic Value = Time Value + Implied Volatility

The amount of a premium that's more than the option's intrinsic value is referred to as its time value. The option has an intrinsic value of $94 ($1,044 - $950) and a time value of $3 ($97 - $94) if Alphabet Inc. stock is priced at $1,044 per share and the Alphabet Inc. $950 call option is trading at $97.

Why Time Value Matters in Options Trading

More time that remains until expiration generally means a greater time value of the option. Investors are willing to pay a higher premium for more time because the contract will have longer to profit from a favorable move in the underlying asset.

Conversely, the less time that remains on an option, the less of a premium investors are willing to pay. The probability that the option has a chance to be profitable is shrinking. It's safer to sell or hold an option that still has time value left for this reason, rather than exercising it. That remaining time value would otherwise be lost.

An option usually loses one-third of its time value in the first half of its term and two-thirds in the second half. Time value decreases faster over time, a process called time decay. The sensitivity of an option's price to time decay is called theta.

The Bottom Line

Time value is the portion of an option’s premium that’s affected by the amount of time remaining until an option contract expires. It’s composed of extrinsic and intrinsic values and can be calculated by a relatively simple math equation. Investors are typically willing to pay more for more time because time gives an asset a sufficient lifespan to manage a profitable move. Less time often means less money for the seller.