Every option position is affected by the passage of time. But each one is affected differently at different points in time. Understanding how this works is vital to our success in trading options.
Every option whose strike price is close enough to the underlying stock’s price has time value. By “close enough,” I mean that the strike price must be near enough to the current price that there is some chance, given the stock’s volatility, that the stock’s price could reach that strike before the option expires.
Below is a list of available options, called the “option chain,” for an exchange-traded fund called EFA.
EFA Option Chain
On the row above in the middle of the diagram, find the row where the Strike (middle column) shows 60. On the left of the Strike column is information about the Call option at that 60 strike, while information about the Put option at that strike is on the right.
The Call at the 60 strike gives its owner the right (but not the obligation) to buy 100 shares of EFA at $60 per share at any time up to the expiration of the option. In this case that is 42 days away, as shown in the gold heading row at the top of the list. Anyone buying that call would do so in the expectation that the price of EFA would go up during the next 42 days, so that $60 would then represent a bargain price.
In the row in the option chain for the 60 strike, the Ask column for the Call option (left side of the chain) shows 0.92. That is the price at which the 60-strike call can be bought.
At the time this snapshot was taken, the price of EFA was $60.07 per share as shown in the Last column at the top of the screen. The $60 strike price of the call would represent a discount of $.07 from the market value of $60.07. That $.07 of real discount to market value is shown in the column labelled “Intrinsic.”
The “Ask” price for the 60 call at this time was $0.92, meaning people were paying that price per share ($92 per 100-share contract). Since the Intrinsic value was only $.07, the remaining $.85 must be something else, something “not intrinsic.” That’s why the column labelled Extrinsic shows $.85.
People were only willing to pay that “additional” $.85 per share because they believed that the price of EFA would go up. If they paid the $.92 for the call now and then exercised their option later, they would pay the additional $60 per share at that time bringing their total investment to $60.92 per share. If EFA at that time were above their $60.92 total cost, they would have a profit. Otherwise they would have a loss.
Another name for Extrinsic Value is Time Value since it only exists because of the chance that the stock could move in the time remaining before the option expires. When the expiration day arrives, because that there is no time left there will be no time value in the option. The option’s total value at that time will be its intrinsic value. If the stock is below $60 at that time, so that the option provides no discount to market value, then the option will have no value at all.
That means that in the next 42 days, the 60 call will lose all of the $.85 in time value that it now has, a little bit each day. This progressive loss of value over time is called “time decay.”
Time decay doesn’t sound like a very good thing for the owner of that option. In fact, all option buyers are in a race against time. For them to make a profit, something has to happen to counteract this inevitable loss due to time decay.
One of those things, of course, would be the stock price going up as the call buyers thought it would. If it does go up above $60.92, as we saw above, then their option would gain enough intrinsic value to replace the lost time value. Once this has happened, any further increase in the stock price would represent clear profit for the call owners, with no limit.
This part of the explanation of time value and its decay is pretty straightforward. As we’ll see in future articles, it gets much more interesting. Mastering the concept of time value and what affects it is a crucial edge when trading options.