Back to basics today.
If you have looked at option trading at all, you probably know that the price of an option has two components: intrinsic value and time value. Intrinsic value is easy to understand; time value is much more interesting.
To dispose of intrinsic value first, think of it as the amount of the built-in discount. If I own a call option at the $98 strike price, on a stock that is trading at $100, then exercising that option would get me the stock at a $2.00 discount. This discount (current stock price minus call strike price) is the call’s intrinsic value. The call will be worth at least that amount (except in rare cases we need not be concerned about).
Puts also have intrinsic value (at least some of them do). If I own a put at the $50 strike price on a stock that is currently at $47, the put gives me the right to turn over 100 shares of the stock and receive $50 per share. This is $3 per share more than the stock is worth. I don’t have to own stock to buy puts; anyone can buy them as a bearish speculation. If that is my situation, in theory I could now buy the stock at the current market price of $47; and then surrender that stock plus the put and receive $50 per share. The $47 I paid in the open market could be said to be a discount to the $50 price I receive for exercising the put. That $3.00 is the put’s intrinsic value.
From the above, it should be clear that the intrinsic value of an option is the difference between the current stock price and the option’s strike price. For calls it is stock price minus strike price; while for puts it is the reverse: strike price minus stock price. In any case where that calculation gives a negative number, then the intrinsic value is zero. That’s why I said that only some puts have intrinsic value – only the ones whose strike price is higher than the current stock price. For calls it is the reverse – those calls with strike prices lower than the current stock price have intrinsic value, while strikes higher than the current stock price do not.
When an option reaches the end of the day on its expiration date, its value will be exactly its intrinsic value. If there is no intrinsic value, then at that time the option will be worthless. That is why options that contain intrinsic value are said to be in the money, and those that don’t are said to be out of the money. At expiration, all of the options for a particular stock that are out of the money are worthless – worth no money.
At any time before an option’s expiration, it may have a value higher than its intrinsic value alone. The excess value is called extrinsic value, or time value. In our example of the $98 call on a $100 stock from above, we know that if the moment of expiration has come, then the value of the call will be exactly its intrinsic value of $100 -$ 98 [stock price minus strike price] which is $2.00 per share.
But if there is time left in the option’s life, it is worth more than $2.00. This is because as long as there is time left, the stock could go higher still before the option expires. The more time there is left before expiration, the more movement is possible in that time. So the more time there is, the more the call option is worth.
It follows that the less time there is remaining, the less time value an option should have. And this is exactly what happens. When an option is first made available on a stock, the option will have a lifespan of anywhere from six weeks (so-called weekly options) to several years (so-called LEAPS or long-term options). The amount of time value at introduction will be largest for the options with more distant expirations, since the stock has scope for much more movement.
Whether an option was born with a scheduled lifetime of six weeks or three years, from that first day on, its time is ticking down. With each day that passes, the amount of possible movement of the stock in the remaining time becomes less. Because of this, the time value portion of an option’s value relentlessly melts away as the remaining days drop down toward zero days. This process is called time decay.
For a concrete example, SPY was trading at one moment on the day of this writing at $263. A call option at the $260 strike had $3.00 of intrinsic value at that point. This was true no matter when the option’s expiration was. Intrinsic value is just stock price minus strike price.
But the time value component in various options at that $260 strike was quite different. In addition to that $3.00 worth of intrinsic value, the options that were due to expire in two years had a whopping $25.90 of time value. Those expiring in two months had $6.18; for those with two weeks to go it was $3.08; and for two days, just $.62. This shows that time value declines with the passage of time.
This phenomenon of time decay is important both to option buyers and to option sellers. For the buyers, it is a hurdle to be overcome. For them, the stock must move in the right direction, so that the time value lost is replaced with intrinsic value. Standing still is not an option. For the people who have sold options short, on the other hand, time is a friend. Time decay reduces the value of the option that they have already been paid for, increasing their possible profit. Ideally for the sellers, the option will be worth zero when it expires, and each day brings that time closer.
Time decay is one of three main forces that affect the time value of an option. In future articles we’ll explore the other two.
Read the original article here - The Difference Between Intrinsic Value & Extrinsic Value