Time Value: Definition, Role in Extrinsic Value, and

Calculation
By
TROY SEGAL

Updated March 30, 2021

Reviewed by
CHARLES POTTERS

What Is Time Value?

Time value refers to the portion of an option's premium that is attributable
to the amount of time remaining until the expiration of the option contract.
The premium of any option consists of two components: its intrinsic
value and its extrinsic value.

Time value is a component of an option's extrinsic value, alongside implied

volatility (IV), and relates to derivatives markets. It should not be confused
with the time value of money (TVM), which describes the discounting of
money's purchasing power over time.

KEY TAKEAWAYS

 Time value is one of two key components, the other being implied
volatility, that comprise an option's extrinsic value.
  An option's total price, or premium, is the aggregation of its intrinsic
and extrinsic value.
 Generally, the more time that remains until the option expires, the
greater the time value of the option.

The Basics of Time Value

The price (or cost) of an option is an amount of money known as
the premium. An option buyer pays this premium to an option seller in
exchange for the right granted by the option: the choice to exercise the
option to buy or sell an asset or to allow it to expire worthless.

The intrinsic value is the difference between the price of the underlying
asset and the strike price of the option. The intrinsic value for a call
option—the right, but not the obligation, to buy an asset—is equal to the
underlying price minus the strike price, while the intrinsic value for a put
option—the right to sell an asset—is equal to the strike price minus the
underlying price.

An option's total premium is based on its intrinsic plus extrinsic value. A

key part of extrinsic value is known as "time value." Under normal
circumstances, a contract loses value as it approaches its expiration date
because there is less time for the underlying security to move favorably. In
other words, an option with one month to expiration that is out of the
money (OTM) will have more extrinsic value than that of an OTM option
with one week to expiration.

Typically, the more time that remains until the option expires, the greater
its time value, as the contract will have longer to become profitable.

Another factor that affects extrinsic value and time value is implied
volatility (IV). IV measures the amount an underlying asset may move over
a specified period. If the IV increases, the extrinsic value will also increase.
For instance, if an investor purchases a call option with an annualized IV of
20% and the IV jumps to 30% the following day, the extrinsic value would
rise as investors figure that dramatic moves boost the possibility of the
asset moving their way.

Calculating Time Value

As an equation, time value might be expressed as:

Option Premium - Intrinsic Value = Time Value + Implied Volatility

Or, to put it another way: the amount of a premium that is in excess of the
option's intrinsic value is referred to as its time value. For example, if
Alphabet Inc. stock is priced at $1,044 per share and the Alphabet Inc.
$950 call option is trading at $97, then the option has an intrinsic value of
$94 ($1,044 - $950) and a time value of $3 ($97 - $94).
Options Premium Components.
Image by Sabrina Jiang © Investopedia 2020

The Significance of Time Value

As a general rule, the more time that remains until expiration, the greater
the time value of the option. The rationale is simple: Investors are willing to
pay a higher premium for more time since the contract will have longer to
profit from a favorable move in the underlying asset.

Conversely, the less time that remains on an option, the less of a premium
investors are willing to pay, because the probability of the option having
the chance to be profitable is shrinking. For this reason, it's safer to sell or
hold an option that still has time value left, rather than exercising it;
otherwise, that remaining time value would be lost.