Time is money
The popular saying “Time is money” certainly applies to options trading. Now, let us take a look at how time can play a major role in succeeding. Let’s say you are taking a very challenging exam; you know you have the intelligence and capability to pass this exam, but if you don’t dedicate an adequate amount of time to studying, your chances of passing significantly decrease. To get a better understanding, consider the correlation between passing your exam and the amount of time spent prepping for it. Ultimately, the more time put into studying for the exam, the higher probability of passing with ease.
It is logical to conclude that the more time devoted to preparation, the greater the likelihood of achieving success in the exam. To use this same logic and apply it to a different situation – if Nifty Spot is 8500 and you buy a Nifty 8700 Call option, what is the likelihood of this option expiring In the Money (ITM)? Let us reword that question to be: What are the chances of success in obtaining an ITM outcome with the purchase of this call option?
We can conclude from the evidence above that, when it comes to an option seller, the longer the expiry time the more likely that option will expire In the Money. This means that the reward they receive, which is limited to the premium they get, will be higher if they sell an option early in the month. The seller also knows that their risk is unlimited and should bear this in mind when deciding.
Given the potential for an option to expire in the money due to the passage of time, it is understandable that an option seller would be wary about selling options. Time can serve as a risk for them, however opportunities to gain compensation for this risk do exist. In actual options trading, when someone pays a premium for options, part of this is in compensation for assumed ‘time risk’. Evaluating this risk against the offered payment should be considered before proceeding.
In other words, the premium of an option can be broken down into two constituent parts: its time value and its intrinsic value.
Let’s consider the Nifty is at 9000:
– 8900 CE
– 9100 CE
– 9000 PE
– 9100 PE
We understand that the intrinsic value can never be less than zero. If it is determined to be figuratively negative, it should be set as 0. Call options have an intrinsic value of Spot Price – Strike Price and Put Options are Strike Price – Spot Price accordingly. Therefore, the values are:
We need to calculate the intrinsic values of these options:
– 8900 CE: 9000 – 8900 = +100
– 9100 CE: 9000 – 9100 = 0 (negative value set as 0)
– 9000 PE: 9000 – 9000 = 0 (negative value set as 0)
– 9100 PE: 9100 – 9000 = +100
Therefore, the intrinsic values for these options are:
– 8900 CE: +100
– 9100 CE: 0
– 9000 PE: 0
– 9100 PE: +100
Now that we are aware of how to ascertain the intrinsic worth of an option, let us try to break down the premium and identify the time value and intrinsic value.
Here’s what you need to note:
The calculation of an intrinsic value for the call option is simple: subtract the spot price from the strike price, which yields a negative number in this case (8,531 minus 8,600). The premium for this option was 99.4 rupees, therefore, time value must have been 99.4—there was no intrinsic value. Strikingly, the market was willing to pay 99.4 rupees for a contract with zero intrinsic value but with plenty of time value.
The underlying has increased to 8538. But the option premium has gone down considerably. The premium can be divided into its intrinsic value and time value. In this case, the difference between the Spot Price and Strike Price would result in a value of 0, indicating a negative intrinsic value. The Premium is 87.9, so its Time Value here is 87.9. We can recognise the huge decline in premium overnight, which is due to a reduction in both volatility and time. It is noticeable that if spot and volatility stayed constant, the change in premium would only be caused by the flow of time, possibly around Rs 5 instead of Rs 11.5 as we see here.
Let’s now take another example.
We know that the intrinsic value of a call option is equal to the spot price subtracted from the strike price, in this case 8514.5 – 8450 = 64.5.
This implies that out of the total premium of Rs.160, traders are allocating Rs.64.5 towards the intrinsic value and Rs.95.5 towards the time value (calculated as 160 – 64.5). The same calculation can be applied to both call and put options to determine the proportion of the premium attributed to the intrinsic and time values for each option.