Mastering Option Greeks

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 24,500 and you buy a Nifty 24,800 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?

What is the probability of Nifty moving 300 points over the upcoming 30 days and consequently the 24,800 CE settling in-the-money?

Let’s imagine today, it is trading at 24,500

The probability that Nifty will rise 300 points in the next 30 days is great, meaning it’s highly likely the option will close in-the-money upon expiry

What if the expiration is only 15 days away?

It is reasonable to expect Nifty to move 300 points over the next 15 days, thus increasing the chance that an option will expire in-the-money (ITM)

In the scenario where there are only five days remaining until the expiry date, what would be the implication?

In just five days, with 300 points at stake, it’s unlikely that 24,800 CE will end up ‘in the money’

What if the expiration is only 1 day away?

The probability that Nifty will move 300 points in one day is unlikely, making it unlikely that the option will end in-the-money, so the chance is low

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 making a decision.

He is aware that he bears the possibility of unlimited risk and limited potential for rewards

He also knows that over time, the option he is selling may become In-The-Money (ITM), meaning he will not be able to keep the premium he received

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.

Time Risk

The intrinsic value of options

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 24,500:

24,300 CE

24,700 CE

24,500 PE

24,700 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:

24,300 CE: 24,500 – 24,300 = +200

24,700 CE: 24,500 – 24,700 = 0 (negative value set as 0)

24,500 PE: 24,500 – 24,500 = 0 (negative value set as 0)

24,700 PE: 24,700 – 24,500 = +200

Therefore, the intrinsic values for these options are:

24,300 CE: +200

24,700 CE: 0

24,500 PE: 0

24,700 PE: +200

Now that we are aware of how to ascertain the intrinsic worth of an option, let us make an effort to break down the premium and identify the time value and intrinsic value.

Check the below image:

Here’s what you need to note:

Spot Value = 24,650

Strike = 24,800 CE

Status = OTM

Premium = 145

Today’s date = Recent trading day

Expiry = Month end

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 (24,650 minus 24,800). The premium for this option was Rs 145, therefore, time value must have been Rs 145—there was no intrinsic value. Strikingly, the market was willing to pay Rs 145 for a contract with zero intrinsic value but with plenty of time value. To prove that point, here is a snapshot of the same contract taken the next day.

The underlying has increased to 24,680. 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 Rs 128, so its Time Value here is Rs 128. 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 7 instead of Rs 17 as we see here.

Let’s now take another example.

Spot Value = 24,620

Strike = 24,400 CE

Status = ITM

Premium = 285

Today’s date = Recent trading day

Expiry = Month end

We know that the intrinsic value of a call option is equal to the spot price subtracted from the strike price, in this case 24,620 – 24,400 = 220.

This implies that out of the total premium of Rs 285, traders are allocating Rs 220 towards the intrinsic value and Rs 65 towards the time value (calculated as 285 – 220). 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.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding time value decay proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending how option premiums break down into intrinsic and time value components enables more informed option selection and timing strategies.