Options and Time Value Part 3

We started the discussion of the Time Value component of an option’s price with an overview of how time affects options positions and continued it with an in-depth look at intrinsic value and time value. Time Value is also called Extrinsic Value, which is probably a more accurate name. The two terms are used interchangeably in this article.

I mentioned that the three main forces that affect an option’s time value are the nearness of the option strike to the current stock price; the time to expiration; and the stock’s volatility. Let’s look at these in turn.

Stock Price

The closer the current stock price is to an option’s strike price, the more extrinsic value that option has. As the stock price moves closer to a strike price, the options at that strike (both the put and the call) gain extrinsic value. If the stock price moves away from the strike, both the put and the call at that strike will lose extrinsic value.

Note the image of the option chain below:

At the time of this snapshot, EFA, the underlying asset for these options, was at $63.81 per share.

The numbers in the blue outlined boxes above show the amount of Extrinsic Value in each option. The blue bar charts show these amounts graphically. Wider bars correspond to larger amounts of extrinsic value.

Note that for both the Call options (left side of the diagram) and the Put options (right side of the diagram), the largest amount of extrinsic value is for the options at the $64 strike. For all the strikes other than $64, the amount of extrinsic value is less and less for strike prices both above and below $64. This is because $64 is the closest strike price to the current stock price of $63.81. That $64 strike price is referred to as the “at-the-money” strike price, or the ATM strike.

Being the at-the-money strike price is not a permanent condition for any option. As the stock price changes, it moves past one strike prices after another. Think of the stock price as sliding up and down the option chain. Whichever strike it is closest to at any point in time is, at that moment, the ATM strike. The options at that strike will have the greatest time value. As the stock moves along on its way leaving that strike behind, the options at that strike lose time value again.

Let’s imagine that the stock moved up instantaneously by $1.00 per share, to around 64.81. The $64 strike would now no longer be at the money; the $65 strike would. The call at the 65 strike would then have the amount of time value that the $64 strike call has now, and the put at the $65 strike would have about the amount of time value that the 64 put has now. The options at the $64 strike would have lost time value, no longer being ATM; and the $65 strike options would take their place as kings of the time-value hill.

It’s as if the entire bar graph slides up or down the chain with the stock price, with the widest bar landing on each strike price as the stock hits that price.

If it helps to comprehend this, you can also think of the amount of time value at a given strike price as being proportional to the probability that the stock will be exactly at that strike when the options expire. Since larger moves are progressively less likely than smaller moves, the current stock price is also the most probable price for it to be in the future – hence the greatest time value.

In our hypothetical $1 up-move, as we said, both the put and call options at the $64 strike would lose time value as the stock moves away from them. They would then have about as much time value as the options that are now at the 63 strike.

As we’ve seen here, there can be a gain or loss of time value in an option even though no time has actually passed. That’s why the people who prefer the alternative term Extrinsic Value have a good point. Nevertheless, most of the world calls it time value, and we’ll do the same for ease of typing if nothing else.

Next time we’ll discuss the effects of volatility and time passing on extrinsic value.

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