Explanation of Time Value (Theta)

Concept of Time Value: 

Time value refers to the value of an option that “still has chance” to increase in price before expiration. The closer the option is to its expiration date, the less time value it has. The further away it is from expiration, the more time value it has.

Calculation Method: 

Time Value = Option Price – Intrinsic Value

The intrinsic value is the profit you would make if you exercised the option immediately, while the time value is the potential profit the option could gain before its expiration.

Factors Affecting Time Value:

Time Until Expiration: The longer the time, the higher the time value, as the option has more time to become profitable.

Volatility: The more volatile the market, the higher the time value, because the option has a greater chance of becoming favorable in the future.

Interest Rates and Dividends: These also affect time value but are relatively more complex. Generally, we can just focus on expiration time and volatility.

Example:

  1. Suppose you have a call option with a strike price of $50, and the current market price is $55. The option price is $8.
  2. Intrinsic Value = $55 (market price) – $50 (strike price) = $5.
  3. Time Value = $8 (option price) – $5 (intrinsic value) = $3. 

In this example, the $3 represents the time value. This $3 is the premium you’re paying for the possibility that the market price could rise further before expiration.

Time Value Decreases Over Time:

  1. As the option approaches its expiration date, the time value gradually decreases, which is known as “time decay.”
  2. By expiration, the time value becomes zero because there’s no more time left for the market price to change.

Visualization: 

You can imagine time value like an ice cube, the closer you get to the expiration date, the faster the ice cube melts. Similarly, the closer the option is to expiration, the faster its time value declines.

In summary, time value is the extra cost you’re paying for the potential future gains of an option, and this “extra cost” decreases over time.