Time Value
The option premium is always greater than intrinsic value. This extra money is for the risk which the option writer/seller is undertaking. This is called the Time Value.
Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying asset. Obviously, the longer the amount of time until the expiry of the contract, the greater the time value. So,
- Time Value = Option Premium – Intrinsic Value
There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here:
- Price of the underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.
- Strike price: How far is the strike price from spot also has an impact on option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000-5100 strike will change a lot compared to a contract with strike of 5500 or 4700.
- Time till expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approaches zero.
- Volatility of underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than let’s say a stable blue chip shares whose fluctuation is more benign at 2-3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.
Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk free income in any case and hence while selling option; he has to earn more than this because of higher risk he is taking.
Read more about this topic: Valuation Of Options
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